INTRODUCTION

TO FINANCIAL ACCOUNTING
MOOC Coursera Wharton October 2014
By Pr. Brian Bushee

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Introduc)on to nancial accoun)ng 1

Chapter 1: Introduc)on 4
Chapter 2: The Balance sheet 10
Chapter 3: Debits and Credit bookkeeping 13
Chapter 4: Accrual accoun)ng and the income statement 20
Revenues and expenses 20
Adjus)ng entries 24
Closing entries and preparing nancial statements 29

Chapter 5: Cash Flows 32

Cash ow categories 32
Methods to prepare the Statement of cash ows 34

Chapter 6: Working capital assets 44

Accounts receivables 44
Inventory 51

Chapter 7: Ra)o Analysis 59

The Dupont ra)os 60

Chapter 8: Long-lived assets and Marketable securi)es 65

Long-lived assets 65
Long-lived assets: Tangible assets 66
Intangible assets and goodwill 71
Marketable securi)es 77

Chapter 9: Time-value of money 85

Future values 86
Present values 87
Annui)es 89

Chapter 10: Long-term debt and bonds 93

Discount and premium bonds 96
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Lease contract 102

Chapter 11: Taxes and the nancial statements 107

Deferred tax liabili)es 111
Deferred tax assets 113
Changes in Future tax rates 116
Valua)on allowances and NOLs 117
Chapter disclosure example 119
Taxes, SCF and Marketable securi)es 125

Chapter 9: Shareholders equity 128

Dividends, splits and AOCI 131
Statement of shareholders' equity and stock compensa)on 134
Earnings per share 136

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CHAPTER 1: INTRODUCTION
To learn a foreign language like Accounting, you need quite a bit of
practice in the basic foundations (grammar, syntax, idioms, etc.). This
material is not fun, but it is absolutely essentially for being able to read
and to understand books written in the language, in our case, the Tinancial
statements.
In the Tirst Tive chapters, we will build these foundations. We will start
with an overview of Tinancial reporting. What types of reports are
required? Who makes the rules? Who enforces the rules? Then, we will
cover the balance sheet equation and deTine/discuss Assets, Liabilities,
and Stockholders' Equity. We will introduce debit-credit bookkeeping and
do lots of practice in translating transactions into debits and credits.
What is Accounting anyway? Accounting is necessary for businessmen,
investors and everyone involved in the life of a company to know what is
happening, make judgments and take adequate decisions. In more
pragmatic terms, accounting is a system for recording information about
business transactions to provide summary statements of a companys
Tinancial position and performance to users who require such information
(shareholders, banks,). To quote some famous investors who are too
famous to be named here, accounting is the language of business.
There are three sets of books:
Financial accounting which includes standardized reports for
external stakeholders
Tax accounting which is used by IRS to compute taxes payable
Managerial accounting, these are custom reports for internal
decision making
The Securities and Exchange Commission (SEC) requires periodic Tinancial
statement Tilings:
10-K: Annual report
10-Q: Quarterly report
8-K: Current report that documents any material event that needs
to be reported to stakeholders
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These reports must be prepared in accordance with Generally Accepted

Accounting Principles (GAAP) in the US. These principles are supposedly
established by the U.S. Congress, but in fact, they delegate to the SEC,
which in turn delegates this work to the Financial Accounting Standards
Board (FASB), constituted by an Emerging Issues Task Force (EITF) and
the American Institute of CPAs (AICPA).
In other major countries, other norms are used, named International
Financial Reporting Standards (IFRS), they are used in over 100 countries
and are issued by the IASB. There is a high degree of overlap between the
two standards, and new guidelines are discussed between FASB and the
IASB.
Still, US GAAP is required for US Tirms and there is a high degree of overlap
in the two standards, so basic principles of accounting and the topics
discussed further will not be affected by the differences.
Responsibility. The management of the company is responsible for
preparing Tinancial statements, and no one else. The Audit Committee of
the board of director provides oversight of the management process and
auditors are hired by the board to express an opinion about whether the
statements are prepared in conformity with GAAP.
The SEC and other regulators may take action against the Tirm if any
violations of GAAP or other rules are found; these breaches might be
discovered by information intermediaries (stock analysts, institutional
investors, media) as they may expose or Tlee companies with questionable
accounting practices.
Required 9inancial statements. The required Tinancial statements for the
SEC and stakeholders are the following
The balance sheet, i.e., gives the Tinancial position (listing of
resources and obligations) on a speciTic date
The income statement, i.e., the results of operations over a given
period of time using accrual accounting, i.e., recognition tied to
business activities
The statement of cash Ilows, i.e., the sources and uses of cash over
a given period of time
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The statement of stockholders equity, i.e., the changes in the

company stockholders equity over the same given period of time

Example. To illustrate the need for so many statements, let us consider the
Tictive example of Daves car transport service. Dave starts a business to
transport expensive cars. On December 1, 2015:
He receives $50,000 cash from issuing common stock
He borrows $80,000 from the bank and buys a $100,000 truck
that will be used for 48 months, with a $4,000 salvage value.
Pays $12,000 cash upfront to rent ofTice space for 1 year
Then during December:
He moves two cars and will get paid $40,000 within 30 days
He pays employees $10,000 of wages
Then, on December 31, the bank wants to see Tinancial statements, and we
try to answer the question: Did the company make money during
December?
Based on Cash Tlows, we can write the following operations:

Stock..$50,000
Bank..$80,000
Truck..($100,000)
Rent...($12,000)
Wage.($10,000)
Customers.....$0
Cash.....$8,000

The problem is that it does not tell us how much the company did earn or
lose in December. We could classify the cash Tlows according to their uses:

Operating cash Tlows: ($22,000)

Rent.($12,000)

Wage..($10,000)

Customers...$0

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Investing cash Tlows: ($100,000)

Truck...($100,000)

Financing cash Tlows: $130,000

Stock...$50,000

Bank...$80,000

Cash...$8,000

This is how is organized a Statement of cash Ilows, it reports cash

transactions over a period of time. The Statement is divided into three
parts:
Operating cash Ilows which are transactions related to the
provision of goods or services and other normal business
activities
Investing cash Ilows which are transactions related to the
acquisition or disposal of long-lived productive assets
Financing cash Ilows which includes transactions related to
owners or creditors
We could look at the business in another way, from an accounting income
perspective, i.e., to look for business activities rather than cash going in and
out. For example, the company did move two cars in December, so, even if
Dave did not get paid $40,000, he is very likely to receive this sum because
he actually performed the service.
Also, even if we paid $100,000 for the truck, we will use it over four years,
which represents a monthly cost of $2,000. Then, Dave paid for one year
rent, but used only one month so far, therefore, it seems fair to book only
an expense of $1,000 for the month. Finally, Dave paid $10,000 to
employees.
Hence, we can look at the picture this way, the Accounting income way:
Revenue...$40,000
Truck expense ($2,000)
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Rent expense($1,000)
Wages expense($10,000)
Net income...$27,000
The Income statement will report the results of operations over a period
of time using accrual accounting as transactions will reTlect business
activities, not cash Tlows.
Revenues will increase owners equity by providing goods or
services
Expenses will decrease owners equity, they are incurred in the
process of generating revenues
Net income (or earnings or net proTit) = revenues Expenses => It
does not equal change in cash!
The next statement will review is the Balance sheet which will provide the
Tinancial picture at the end of the month. By Tinancial position, we mean
the resources and obligations. The resources are what we call Assets; the
company has:
Cash.$8,000 (cash in the bank on 12/31/2015)
Accounts Receivable$40,000 (cash owed by customers 12/31/2015)
Prepaid Rent.$11,000 (Prepaid for 11 months 12/31/2015)
Truck.$98,000 ($100,000 - $2,000 depreciation)

Total$157,000
The obligations are the following:
Bank debt.$8,000 (cash owed to bank on 12/31/2015)
Common stock $50,000 (Stockholders 12/31/2015)
Retained earnings..$98,000 (Net income - Dividends)

Total$157,000
The Balance sheet reports the Tinancial position (resources and
obligations) of a company on a speciTic date.
Assets are resources owned by a business; they are expected to
provide future economic beneTits.
Liabilities are claims on assets by creditors (non-owners) that
represent an obligation to make future payment of cash, goods, or
services.
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Stockholders equity (Owners equity) are claims on assets by

owners of business. They have two sources:
o Contributed capital, arises from sale of shares
o Retained earnings, arises from operations

The last statement is the Statement of Stockholders equity, but we will take
a look at it later.
The accounting cycle. During each period, we will go through all these
steps to prepare Tinancial statements for the period:
during the period, we will analyse the company transactions
we then journalise and post them to get the Unadjusted trial
balance at the end of the period
we adjust the entries and prepare Adjusted trial balances
we prepare the Tinal statements
Tinally, we close the temporary accounts and start a new period
In the next chapters, we will follow the accounting cycle as a guide.

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CHAPTER 2: THE BALANCE SHEET

In this chapter, we will take a closer look at the Balance sheet components
and at the balance sheet equation.
Assets. An asset is a resource that is expected to provide future economic
beneTits) i.e., generate future cash inTlows or reduce future cash outTlows.
An asset is recognized when:
it is acquired in a past transaction or exchange and
the value of its future beneTits can be measured with a reasonable
degree of precision.
Example of assets. For the following examples, try to Tind if an asset is
recognized.
Battle of Cohorts (BOC) sells $100,000 of merchandise to a customer that
promises to pay cash within 60 days.
Answer: accounts receivable, $100,000, we delivered the goods and
we can get cash in exchange within 60 days. It can be estimated as we have
an invoice.
BOC signs a contract to deliver $100,000 of natural gas to DEF each month
for the next year.
Answer: no asset involved, no past transaction or exchange.
BOC buys $100,000 of chemicals to be used as raw materials. BOC pays in
cash at time of delivery and receives a 2% discount on the purchase price.
Answer: inventory, $98,000
BOC pays $12 million for the annual rent on its ofTice building. It has
already occupied it for one month.
Answer: Prepaid rent, $11 million. Both criteria are met, and we
already used up one month.
BOC buys a piece of land for $100,000. Its broker says this was a steal
because the land is probably worth $150,000.
Answer: Land $100,000
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BOC is advised by a marketing Tirm that its brand name is worth $63
million.
Answer: no asset involved, not acquired and not reasonable degree of
precision.
Liabilities. A liability is a claim on assets by creditors (non-owners) that
represents an obligation to make future payment of cash, goods, or
services. A liability is recognised when:
The obligation is based on beneIits or services received currently
or in the past
The amount and timing of payment is reasonably certain
If we borrow to a bank, we have an obligation to repay the bank based on
the beneTit of getting the money now. Amount and timing are known.
Example of liabilities. For the following examples, try to Tind if a liability
is recognised.
BOC receives $300,000 of raw materials from its supplier and promises to
pay within 60 days
Answer: Accounts payable, $300,000. BeneTit of getting the raw
materials with the obligation of paying them in 60 days.
Based on this quarters operations, BOC estimates that it owes the IRS $3
million in taxes.
Answer: Income tax payable, $3 million. It is just an estimate but it is
reasonably accurate.
BOC signs a three-year, $120 million contract to hire Dakota Dokes as its
new CEO, starting next month.
Answer: $0. No liability, no beneTits received yet.
BOC has not yet paid employees who earned salaries of $1,000,000 during
the most recent pay period.
Answer: Salaries payable, $1,000,000. They worked, we already
received the beneTits.

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BOC borrows $500,000 from a bank on a one-year note with a 10%

interest rate
Answer: Notes payable, $500,000. Interests are not yet a liability.
BOC is sued by a group of customers who claim their products were
defective. The suit claims of $6 million.
Answer: No liability, because the amount is not reasonably certain.
Stockholders equity. Stockholders equity is the residual claim on assets
after settling claims of creditors (=assets-liabilities), it is also called net
worth, net assets, net book value.
There are two sources of Stockholders equity:
Contributed capital, which arises from sale of shares
o Common stock at par value
o Additional paid-in-capital, in excess over par value
o Treasury stock, i.e., stock repurchased by company
Retained earnings, which arises from operations
o Accumulation of Net income (revenues minus expenses),
less dividends, since start of business
o Retained earningsEnd = Retained earningsBeg + Net income
- Dividends
Dividends are distributions of Retained earnings to shareholders; they are
not an expense and are recorded as a reduction of retained earnings on the
declaration date that creates a liability until payment date. Dividends are
not an expense because they are not a cost of generating a revenue, they
are a return on funds invested by the shareholders.

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CHAPTER 3: DEBITS AND CREDIT BOOKKEEPING

Remember, for increases, Debit increases Expenses and Assets (DEA)
Credit increases Revenues, Liabilities and Stockholders' equity (CRLS,
pronounced "curls").
So goes the song:
DEA and CRLS!
DEA and CRLS!
And you will all be
Happy boys and girls!
Debits, Credits and the Balance sheet equation. The most interesting
thing about bookkeeping is that it is the only word in the English language
with three consecutive sets of double letters oo kk ee. There are three
fundamental bookkeeping equations:
Assets = Liabilities + Stockholders equity
Sum of Debits = Sum of Credits
Beg. Account balance + Increases Decreases = End. Account
balance
These three equations must balance at all times. The balance sheet
equation can be preserved through the use of debits and credits. The
deTinitions of Debit and credit are the following:
Debit (Dr.) = left-side entry
Credit (Cr.) = Right-side entry
In the accounting world, credit and debit do not have the same
connotation as in the outside world, they just mean left and right. Now
lets look closer how Debits and Credits help us maintain the integrity of
the Balance sheet equation:
Assets = Liabilities + Shareholders equity
Assets = Liabilities + Contrib. cap. + Ret. Earnings + Rev. Exp.
Assets + Exp. = Liabilities + Contrib. cap. + Ret. Earnings + Rev.

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Debits = Credits
Items on the left of the equation will be considered Debits accounts and
the ones on the right, Credits accounts.
Rules for every transaction with Debits and Credits:
It must have at least one Debit and at least one Credit
Debits must always equal Credits
No negative numbers are allowed
Accounts. Accounting is named the way it is because we put everything
into accounts. Each account has a type of normal balance (Debit or Credit)
that the account carries under normal circumstances.
We will represent accounts in the form of T-accounts that will record all
changes in the accounting quantity:
Debits are listed on the left side of the T
Credits are listed on the right side of the T
The account balance will be the difference between the sum of Debits and
the sum of Credits for the account, and, for each account, the change in
Account balance equation will be the following: Beg. Balance + Increases
Decreases = Ending balance.
Type of accounts. Assets and Expenses will have a normal balance of Debit.
Accounts Receivable (A)
Beg. Balance 1,000
New sales (Increase) 100

80 Cash collections (Decrease)

End. Balance 1,020

Liabilities, Stockholders equity and revenues have a normal balance on that

increases on the Credit side (Right) and decreases on the Debit side (Left).

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Accounts Payable (L)

1,000 Beg. Balance
Cash payment (Decrease) 80

100 New purchases (Decrease)

1,020 End. Balance

Super T-account. Another way to picture the Debit and Credit accounting
system and the impact of Debit and Credit on various accounts is the use
the Super T-account.

Assets

Liabilities & Stock holders' equity

Assets

Liabilities

Contr. Cap.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

X-assets

Retained earnings

Dr.

Cr.

Dr.

Cr.

Expenses

Revenues

Dr.

Cr.

Dr.

Cr.

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When analysing a transaction, we are going to ask ourselves three

questions:
Which speciTic Asset, Liability, Stockholders equity, revenue or
expense accounts does the transaction affect?
Does the transaction increase or decrease the affected accounts?
Should the accounts be debited or credited?
Then, we will proceed to the Journal entry which will have the following
format:
Dr. <Name of Account debited> $XXX
Cr. <Name of Account credited> $XXX
Now, raise your hand and repeat out loud: I solemnly swear that I will
always list Debit Tirst, that I will always list Credit second and that I will
always indent my credits!.
Now, we are ready to start our accounting cycle and start post (to the
journal as a journal entry) and journalise (to T-accounts):

Examples. Now, we will take a look at the four types of possible

operations.
Example 1: Increase an asset and increase a liability or equity. We receive
$100 cash from a bank loan. On the Balance sheet equation we will have an
increase in Cash (+A) and an increase in Liabilities (+L). Journal entry:
Dr. Cash (+A) $100
Cr. Notes payable (+L) $100
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T accounts:
Cash (A)

Bal
.

Notes payable (L)

100

100

100
Bal
.

100

Example 2: Decrease an asset and decrease a liability or equity. We repay

$20 of a bank loan. We will have a decrease in cash (-A) and a decrease in
Notes payable (-L). Journal entry:
Dr. Notes payable (-L) $20
Cr. Cash (-A) $20
T accounts:
Cash (A)

Bal
.

Notes payable (L)

100

20

80

20

100
Bal
.

80

Example 3: Increase an asset and decrease an asset: we pay $10 cash for
inventory. Here, Cash decreases (-A) and Inventory increases (+A). Journal
entry:
Dr. Inventory (+A) $10
Cr. Cash (-A) $10
T accounts:
Cash (A)
100

Bal
.

Inventory (A)
20
10

70

Bal.

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10

10

Example 4: Increase a liability or equity and decrease another liability or

equity: we issue $80 in Common stock to pay off the bank loan. The journal
entry is the following:
Dr. Notes payable (-L) $80
Cr. Common stock (+L) $80
T accounts:
Common stock (SE)

Notes payable (L)

80
80

20
Bal.

80

100

0

Bal
.

Journal entry practice. BOC issues 10,000 shares of $5 par value stock
for $15 cash per share.
Answer: Dr. Cash (+A) $150,000

Cr. Common stock (+SE) $ 50,000

Cr. Add. Paid-in Cap. (+SE) $100,000
BOC acquires a building costing $500,000. It pays $80,000 cash and
assumes a long-term mortgage for the balance of the purchase price.
Answer: Dr. Building (+A) $500,000

Cr. Cash(-A)
$ 80,000

Cr. Mortgage payable (+L) $420,000
BOC obtains a 3-year Tire insurance policy and pays the $3,000 premium in
advance.
Answer: Dr. Prepaid insurance (+A)
$3,000

Cr. Cash (-A)

$3,000
BOC acquires on account ofTice supplies costing $20,000 and merchandise
inventory costing $35,000.
Answer: Dr. OfIice supplies (+A)
$20,000

Dr. Inventory (+A)

$35,000

Cr. Accounts Pay.
$55,000
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BOC pays $22,000 to its suppliers.

Answer: Dr. Accounts payable (-L)

Cr. Cash (-A)

$22,000
$22,000

BOC exchanges a building valued on the books at $200,000 for a piece of

undeveloped land.
Answer: Dr. Land (+A)

$200,000

Cr. Building (-A)

$200,000
BOC retires $1,000,000 of debt by issuing 100,000 shares of $5 par value
stock
Answer: Dr. LT Debt (-L) $1,000,000

Cr. Common stock (+SE) $ 500,000

Cr. Add. Paid-in Cap. (+SE) $500,000
BOC receives an order for $6,000 of merchandise to be shipped next
month. The customer pays $600 at the time of placing the order.
Answer: Dr. Cash (+A)

$6,000

Cr. Advances from C (+L)
$6,000
BOC pays $8,000 dividend.
Answer: Dr. Ret. earnings (-SE)

Cr. Cash (-A)

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$8,000
$8,000

CHAPTER 4: ACCRUAL ACCOUNTING AND THE INCOME

STATEMENT
All income statement items are based on accrual (accumulation)
accounting principles, that is, to track the revenues and expenses when they
actually occur. Accrual accounting gives a very different picture of a
companys performance than the one given by its cash Tlows. The income
statement objective is to report the increase or decrease in shareholders
equity due to operations over a period of time. Net income, which also can
be called earnings or net proTit is the primary outcome of the income
statement and is calculated as follows:
Net income = Revenue - Expenses
Accounting recognition of revenues and expenses are tied to the various
business activities, not to when the cash Tlows are spent or received.
Revenues are recognised when goods or services are provided
(revenue recognition criteria). Revenues Cash inTlows.
Expenses are recognised in the same period as the revenues they
helped to generate, not necessarily when cash is paid, this is what
we call the matching principle. Net income Cash outTlows
Net income Cash Ilows
After seeing the criteria used to recognize the revenues and expenses, we
will go through the adjustment of entries and see how accrual accounting
is Titting in the accounting cycle.

Revenues and expenses

Revenue. Revenue is an increase in shareholders equity, not necessarily
cash, from providing goods or services. These two criteria, which are
called revenue recognition criteria, must be satisTied so that revenue is
recognised:
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It is earned, i.e., goods or services are provided and

It is realized, i.e., payment for goods or services received in cash or
anything that can be converted to a known amount of cash, like an
invoice.

Example where the Iirst criteria, earned is not straight-forward. You pay a
$100 for software to Company X. The second criterion is met, because they
collected the cash, it is therefore realized. But the company might not be
able to fully book the revenue because it is not totally earned as you paid
not only for the codes today but also for updates, patches or technical
support. So, the company could book $80 now and book the rest of the
revenues when other services are provided.
Example where the second criteria is not met. A turnaround expert CEO
who used to be hired by the stressed company to take aggressive
decisions, streamline the operations or reduce workforce to turnaround
the company quickly. On one of his stops, he ended up shipping products
to customers that did not order anything at the end of the quarter. The fact
that it was shipped allowed the company to book the revenue, and to reach
the target set. The problem is that, as the customers did not order the
product, they will end up returning it. The company got in trouble with the
SEC commission for this doubtful accounting practice.
Overall, 50% of the enforcement actions by the SEC commission are
for violations of one of these two rules.
Examples of revenue recognition. For the following examples, try to Tind
if a revenue has to be booked for the month of December.
BOC delivers $500,000 worth of washing machines in December to
customers who dont have to pay until February.
Answer: $500,000. The goods were delivered and there is an invoice
that is scheduled to be paid in February.
BOC collects $300,000 cash in December for washing machines to be
delivered in October.
Answer: $0. The revenue has already been recognized in October. Its
just cash collection.

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BOC Realty leases space to a tenant for the months of December and
January for $20,000, all of which is paid for in cash in December.
Answer: $10,000. Cash is received, so its realized, but so far, only the
month of December has been earned.
BOC Aerospace receives an order for a $400,000 jet in December to be
delivered in July.
Answer: $0. The good is not delivered.
BOC bank is owed $100,000 of interest on a loan for December and
receives the payment in January.
Answer: $100,000.
BOC issues 20,000 shares of stock in December and receives $10 per
share, which is $/share more than they expected.
Answer: $0. A company cannot be booked when it issues share.
Expenses. Expenses are decreases in shareholders equity, not necessarily
cash, that arise in the process of generating revenues; they are recognized
when either:
Related revenues are recognized, i.e., product cost or
Incurred, if difTicult to match with revenues, i.e., period costs and
unusual events
Example of a company manufacturing cameras. In this case, the product
costs would be all direct costs to produce the camera would include all the
direct cost of raw materials, i.e., the glass for the lenses, the plastic, the
electronic components and the overhead costs, i.e., labor, electricity. When
the product is sold all these costs are booked, so the product costs follow
the product. There are other costs of running a business such as marketing
and sales, research and development, human resources, top management,
etc. These costs, called period costs, are not associated with a product, and
are recognized when they occur.
The underlying recognitions concepts are the:
Matching principle, either to a product (product costs) or a period
( period costs)

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Conservatism principle for unusual events: recognize anticipated

losses immediately, recognize anticipated gains only when
realized

The conservatism principle goes against human nature which tends to do

the opposite, i.e., recognizing gains now and losses latter. Note: the term
expense will be used for items that are recognized and will appear in the
income statement; in contrast cost will be used more loosely for any cash
outlay.
Examples of expenses recognition. For the following expenses, try to Tind
how much expense are recognized in December.
BOC automotive buys engine worth $2,000,000 in December for cash.
Answer: $0. Engines are going to be a product cost.
BOC automotive uses the engines to make cars at a total cost of
$10,000,000 in December.
Answer: $0. The cars are still not sold.
BOC automotive sells cars costing $8,000,000 in December for
$15,000,000.
Answer: $8,000,000. We sold the cars.
BOC automotive incurs $180,000 in salaries for its marketing staff in
December.
Answer: $180,000. This is a period cost.
BOC automotive pays its auditor $50,000 in December for services to be
rendered in December and January.
Answer: $25,000. We can only recognize the work done in December.
BOC automotive pays $1,200,000 in cash dividends in December.
Answer: $0. Dividends are never recognized as an expense.

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Adjusting entries
Now that the period is Iinished, we have analysed, journalised and posted
all the transactions of the period; it is time to start preparing the periods
Tinancial statements. To do so, we will Tirst prepare an unadjusted trial
balance. This trial balance needs to be adjusted for unaccounted revenues
and expenses that occur on a continuous basis. The objective is to get a
true economic picture of the company, but this gives the management
some room for interpretation, which can sometimes mean creative
accounting. We are here in our accounting cycle:

Internal transactions that update account balances in accordance with

accrual accounting prior to the preparation of Tinancial statements. None
of the adjusting entries ever involve cash, they are purely internal
transactions.
Deferred revenues and expenses are necessary to update existing account
balances to reTlect current accounting values, the cash Tlow is in the past
and we just record the revenue now. Deferred Pay Record (DPR)
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On the opposite, we have accrued revenues and expenses that are used to
create new account balances to reTlect unrecorded assets of liabilities, we
record the revenue or the expense now but the cash Tlow has no occurred
yet. Accrued Record Pay (ARP)
Here is a summary of the different adjusting entries that we will detail
later on:



Deferred expense
Dr. Prepaid Asset
Cr. Cash

Dr. Expense
Cr. Prepaid Asset
Deferred revenue

Dr. Asset
Cr. Cash

Dr. Expense
Cr. Asset

Cash transaction

Recognition end of period

Cash transaction

Accrued expense
Dr. Expense
Cr. Liability

Dr. Liability
Cr. Cash
Accrued revenue

Dr. Asset
Cr. Revenue

Dr. Cash
Cr. Asset

Deferred expense. The accountant, at the end of the period will try to
answer the following question: are there any assets that have been used
up this period and should be expensed?
Examples:
Prepaid rent,
Prepaid insurance,
Depreciation and amortization.

Page 25

We already paid the cash for the goods or services in the past, and now
recognise how much of the goods we have consumed. Managers have the
choice of allocating the expense according to time or usage. For example, if
an advertisement campaign runs through one year, and most of it, lets say
70% of it is taking place on the Tirst half of the period; managers can
allocate 70% of the expense to this period.
To adjust a prepaid asset that has been used up to the end of the year we
are going to book an expense (Debit Expense) and reduce the value of the
prepaid asset (Credit Prepaid asset). Therefore, the journal entry will look
like this:
Dr. Expense
Cr. Prepaid Asset
Depreciation and amortization. We have a speciTic set of deferred expenses,
these are depreciation and amortization. The objective of these expenses
is to allocate the original cost of a long-lived asset over its useful life, and
match the total cost of this asset to the revenues it generates over its
period of use.
In terms of terminology, we will use the following rule:
Tangible assets (physical assets) require depreciation
Intangible assets (abstract assets) require amortization
In terms of procedure, depreciation is not deducted from the tangible asset
account. Rather, it is recorded in a Contra asset account (XA) called
Accumulated depreciation, which:
Has a credit balance, but stands with the assets
Is subtracted from PP&E on the balance sheet to get the Net book
value
We do this to keep track of the original value of PP&E, to know where
we stand in the depreciation process.
On the intangible assets side, amortization is often, but not always,
deducted directly from the intangible asset account.

Page 26

To calculate the amount of depreciation expenses to be accounted for

every year, almost every company uses a method called straight-line
depreciation.
Depreciation expense = (Original cost - salvage value) / Useful life
The salvage value is what you think the asset will be worth at the end of its
life, and the useful life is the number of period on which you plan to
depreciate the asset. So, the amount of depreciation under this method
will be the same every year.
There are also some more aggressive depreciation methods where we
depreciate faster in the Tirst years, and then less at the end of the useful
life. These methods are used for tax purposes, i.e. to increase the
depreciation burden and reduce tax.
Deferred revenue. In this case, the accountant will try to answer the
following question: are there liabilities that have been fulTilled by delivery
of goods or services that should be recognized as revenues?
Examples:
Unearned rental
Deferred subscription revenue
In this case, we received cash prior to providing goods or service and now
we have earned a part (or in total) this revenue that we need to recognize.
We will thus need to decrease the unearned revenue liability (Debit
Unearned Revenue Liability) and book the revenue (Credit revenue). The
entry will look like this:
Dr. Unearned revenue liability
Cr. Revenue
Accrued expense. The accountant will then ask himself: Have any
expenses accumulated during the period that have not been recorded?
Examples:
Income tax payable
Interest tax payable
Page 27

Salaries and wages payable

These accounts are all payable type of accounts; we have incurred some
expenses over time, but did not pay it cash yet. For example, if we did not
pay the salaries for the current month, we will have to make an adjustment
to increase an expense (Debit expense) and book a liability in salaries and
wages payable (Credit Salaries and wages payable. In general, an accrued
expense entry will look like this:
Dr. Expense
Cr. Payable liability
Accrued revenue. Finally, the accountant will ask himself is any revenues
have been accumulated during the period that have not yet been recorded.
Examples:
Interest receivable
Rent receivable
Time have passed and we earned some revenues on a loan or rent, we will
therefore recognize a revenue (Credit Revenue) and book a receivable
asset (Debit Receivable asset) so that the entry will look like this;
Dr. Receivable asset
Cr. Revenue

Page 28

Closing entries and preparing 9inancial statements

These are the last two stops in the accounting cycle; we already prepared
the trial balance, adjusted the entries, now we ail prepare the Adjusted
trial balance and the Tinancial statements.

Adjusted trial balance. The adjusted trial balance summarizes balances

in each account after adjusting entries, which will then be used to prepare
Tinancial statements
Preparation of 9inancial statements. We will:
Prepare the Income statement Tirst, then
Use the Net income calculated to update Retained earnings and to
prepare the Balance sheet, and Tinally,
Complete the Statement of cash Tlows and Statement of
Stockholders equity.

Page 29

The income statement generally has the following format:

Revenue (or Sales)

- Cost of Goods Sold
Gross ProIit
- Operating (SG&A) Expense
Operating Income
- Interest, gains and losses
Pre-tax income
- Income Tax Expense
Net Income

For the Balance sheet, assets are listed Tirst in the following order:
Current assets (beneTits within next year) are ordered by liquidity,
i.e., how readily can they be converted to cash. They include Cash,
Account receivables, Inventory and Prepaid assets.
Non-current assets, which include Tangible and Intangible Assets.
Then comes liabilities:
Current liabilities (obligations within next year) which are also
ordered by liquidity. They include Bank borrowings, Accounts
payable and other payables and Deferred revenues and other
noncash liabilities.
Noncurrent liabilities, which include longer term bank borrowings
and bonds, Deferred taxes, pensions.
Finally, we have Stockholders equity:
Contributed capital
Retained earnings
When we are Tinished with the Tinancial statements, we are ready to do the
last step of the accounting cycle, closing entries.
Closing entries. Closing entries involves closing temporary accounts.
Temporary accounts accumulate the effects of transactions for a period of
time only and which are closed at the end of the period. These are Revenue
and Expenses accounts.

Page 30

Permanent accounts accumulate the effects of transactions over the entire

life of business, these are found on the Balance sheet: Assets, Liabilities,
Contributed capital, Retained earnings.
The closing entries are internal transactions that zero out temporary
accounts at the end of the accounting period, the objective is to transfer
the revenue and Expenses account balances to Retained earnings. To
zero the Revenue accounts out, we will do the following entry:
Dr. Revenue Accounts (-R, -SE)
Cr. Retained earnings (+SE)
For expenses, we will do the following:
Dr. Retained earnings (-SE)
Cr. Expense accounts (-E, +SE)
After closing entries, we do a Post-closing trial balance that summarizes
the balances of permanent accounts after closing entries and all revenue
and expense accounts should have a zero balance.
Now, were ready to start the next Tiscal period.

Page 31

CHAPTER 5: CASH FLOWS

Not so fast, so far we have talked about the Balance Sheet, the Income
statement, but we are still missing the Statement of cash Tlows. In this
chapter, we are going to see how to classify cash Tlows according to three
categories, Operating, Investing and Financing activities.
Statement of cash 9lows. The Statement of cash Tlows is going to report
changes in cash due to operating, investing, and Tinancing activities over a
period of time, according to the following format:
Net cash from Operating activities +
Net cash from Investing activities +
Net cash from Financing activities =
Net change in cash balance.
We separate into these categories because we clearly want to know how
the business is operating. Non-cash transactions are disclosed at the
bottom of the statement, cash interest paid and cash income taxes paid
must be also be disclosed. We will Tirst allocate cash transactions to a Cash
Tlow category and then prepare the Cash Tlow statement.

Cash 9low categories

Operating activities. These are transactions related to providing goods
and services to customers and to paying expenses related to generating
revenue i.e., income statement activities (also generally less than 1 year).

Collections from customers

Receipts of interest and

dividends on investments

Operating activities

Payments to suppliers

Payments to employees

Payments of interest and tax

Page 32 Other op. disbursements

Operating cash outTlows exclude these income statement items:

Depreciation and amortization and other noncash items
Gains or losses on disposal of PP&E
Investing activities. In this, sections we will have transactions related to
acquisition or disposal of long-term assets, except for Interest payments.

Divestitures of businesses

Sale of PPE & Intangibles

Sale of investments

Investing activities

Acquisition of investments

Acquiring of businesses

Acquisition of PPE & Int.

Financing activities. These transactions are related to owners or

creditors, except for interest payments, FASB ruled that it should be in the
Operating CF section. It is different in IFRS, interests and dividends can be
anywhere as long as it is consistent.

Issue of new stock

Reissue treasury stock

Borrow money

Financing activities

Payment of dividends

Payment of principal debt

Purchase of treasury stock

Page 33

Methods to prepare the Statement of cash 9lows

There are two different methods to prepare the Statement of cash Tlows,
after allocating the different cash transactions to one of these three
categories.
The direct method. In the direct method, we list cash receipts and
disbursements by source/use of funds. It is always used for Investing and
Financing activities but rarely for Operating Cash Tlow. This is the easy
part.
The Indirect method. This method is only used for Operating activities;,
we calculate the cash Tlow statement starting from Net income. The
objective is to reconcile Net income with Cash from operations by
removing noncash items from Net income and including additional cash
Tlows not Net income. And make sure everything is right. This is the tricky
part.
To summarize:
Operating CF: Direct or Indirect method
Investing CF: Direct method
Financing CF: Direct method
For the indirect method, we will:
Start with Net income
Adjust for components of Net income tied to noncash items or to
investing activities:
o Add back expenses or subtract revenues
o Noncash items: Depreciation, amortization
o Investing activities: gains/losses on sale of PP
Adjust for components of Net Income tied to assets or liabilities
created through Operating activities (i.e., Working capital):
o Add or subtract change in asset/liability account balance
o Use the Balance sheet equation to determine whether to
add or subtract:
Cash + Noncash assets = Liabilities + Owners equity

Page 34

We will now practice to illustrate this method more clearly.

Examples. Example 1, we get $100 sales in cash, with a COGS of $60, we
prepare the Income Statement and the Statements of Cash Flow (SCF) with
the Direct method and then with the Indirect method.
Income

Direct SCF

Sales $100 cash

COGS $60 inv. cash
Net income

10
0
-60

Collections
Payments

40

Indirect SCF
10
0
-60

OCF

Net income

40

40

OCF 40

Example 2, same as before but with a depreciation expense of $10.

Income

Direct SCF

Sales $100 cash

Collections

COGS $60 inv. cash

10
0
-60

Depreciation: $10

-10

Net income

Indirect SCF
Net income

30

Payments

10
0
-60

add Dep. Exp.

10

30

OCF

40

OCF 40

Example 3, same but with a payment made $80 in cash and $20 later,
booked in Accounts receivables (AR). The AR will have to be adjusted
using the Balance sheet equation; an increase in AR (+A) is compensated
by a decrease in Cash (-A).
Income

Direct SCF

Sales $80 cash $20 AR

Indirect SCF

Collections

80

Net income

30

COGS $60 inv. cash

10
0
-60

Payments

Add Dep. Exp.

10

Depreciation: $10

-10

-6
0
20

OCF

Net income

30

OCF

Page 35

Incr. in AR

-20
20

Example 4, same but with Inventory paid $75, paid cash $50 and $25 going
to A/P, same COGS of $60.
Income

Direct SCF

Sales $80 cash $20 AR

COGS $60 inv. Cash

10
0
-60

Indirect SCF

Collections

80

Net income

30

Payments

-5
0

Add Dep. Exp.

10

Inv. $75, paid Cash $50

A/P $25
Depreciation: $10

-10

Net income

30

OCF

Incr. in AR

-20

Incr. in Inv.

-15

Incr. in A/P

25

30

OCF

30

Treatment of gain on PPE. Lets say that we sold PPE worth $70 on the
books for $75 cash. That will result in a gain of $5 that will go on the
Income statement, but all $75 of cash is considered Investing cash Tlow.
Income

Direct SCF

Sales $100 cash

COGS $60 inv. cash

10
0
-60

Depreciation: $10

-10

Gain on sale of PPE

Collections

35

10
0
-60

Payments

Net income

Indirect SCF

Net income

35

add Dep. Exp.

10

Less Gain

-5

OCF

40

OCF 40

Proceeds from
Sale
Investing CF

75

Proceeds

75

75

Investing CF

75

In the Indirect method of calculating the Operating cash Tlow, we have to

subtract the Gain on the sale of PPE, otherwise we would count it double.
Gain in, Gain out.
Page 36

Statement of cash 9lows complications. Sometimes the numbers in the

balance sheet numbers often not equal the number in the Statement of
cash Tlows. This can be because:
Noncash investing and investing activities that will require
supplemental disclosure below SCF. A customer cannot pay cash
and instead give a piece of land, this would show in the Balance
sheet but not in the Cash Tlow statement.
Acquisition and divestitures of businesses. Investing activities that
affects balances in operating asset and liability accounts. If we
purchase a company, we will consolidate the AR in the Balance
sheet but not in the Statement of cash Tlow as it is already counted
in the Investing part.
Foreign currency translation adjustments. Changes in cash due to
exchange rate movements are shown separately.
Subsidiaries in different industries. Some transactions, e.g. buying
land are investing activities in one part of business and operating
in another.
Disagreement over FASB classi9ication. Many investors prefer to classify
interest payments as a Tinancing activity. Under US GAAP, cash paid for
interest must be disclosed so analysts can adjust themselves the
Statement. Some also consider interest and dividends as an investment
activity
All income tax effects are shown in the operating section, even if the
income relates to Tinancing of investing activities. Cash taxes are also
disclosed so you can remove it from your calculation.
EBITDA, Earnings, and Cash 9lows. EBITDA, Earnings Before Interest,
Taxes, Depreciation, and Amortization, is often used as a proxy for cash
Tlow that excludes interest and taxes.
However, EBITDA does not measure cash Tlow well if there are large
changes in Working capital and suffers from the same manipulation
potential as Net income. For example, channel stufTing would increase
earnings and EBITDA, but no cash collected (instead accounts receivable
increase). Subtracting the increase in AR from EBITDA would correct this
problem.
Page 37

Research Tinds that Earnings are a better predictor of future cash Tlows
than current Cash Tlow from operations, but using both, gives the best
predictor.
Free Cash 9low. When people talk about Free Cash Tlow, they usually mean
Operating cash Tlow minus cash for long-term investments. The problem is
that there is no standard measure for operating cash Tlow. Examples from
different textbooks include:
Cash from operations before interest expense
NOPLAT (Net operating proTits less adjusted taxes) = EBITDA
cash taxes on EBITDA. Not a good measure
NOPAT increase in Working capital. NOPAT = Net income + After
tax net interest expense
EBITDA, EBIT(1-tax rate) + Depreciation,
Another problem is that companies often use their own custom deTinition
of Free cash Tlow.
The Purple and Green companies. We will use the example of Purple Inc.
and Green Co. to illustrate the Cash Tlow and EBITDA concepts developed
in this chapter. Here is the Income statement for the two companies:

Purple Inc.

Green Co.

Sales

$500,000

$500,000

COGS

265,000

315,000

Gross margin

235,000

185,000

75,000

Restructuring charge
Interest expense

14,000

13,000

Loss (Gain) on Sale of Assets

-10,000

20,000

Pretax Income

231,000

77,000

81,000

27,000

150,000

50,000

Income Tax Expense

Net Income
Page 38

Here are some additional information on the two operations. For Purple
Inc. and Green Co.:

Purple Inc.

Green Co.

Depreciation

COGS included $50,000 of

depreciation in 2012

COGS included $100,000 of

depreciation in 2012

Restucturing liability

No

Recognized a $75,000
liability in 2012. No cash
involved yet

Proceeds from sale of

equipment

$30,000 during 2012,

including a $10,000 gain

$50,000 during 2012,

including a $20,000 loss

Capital expenditures

$220,000 of CAPEX

$70,000 during 2012

Proceeds from issuance of $50,000 during 2012

long-term debt

No new debt issued

Payments of long-term
debt

$35,000 during 2012

$95,000 during 2012

Dividends paid

No dividend

$60,000 during 2012

Accounts receivables

Inc. by $100,000

Dec. by $100,000

Inventory

Inc. by $50,000

Dec. by $50,000

Prepaid expenses

Dec. by $100,000

Inc. by $25,000

Accounts payable

Inc. by $75,000

Dec. by $75,000

Interest payable

Inc. by $10,000

Dec. by $70,000

Page 39

From this information, we can prepare the following Statement of cash

Tlow:

Purple Inc.

Net income

Green Co.

$150,000

$50,000

50,000

100,000

75,000

-10,000

20,000

-100,000

100,000

Change in Inventory

-50,000

50,000

Change in Prepaid exp.

100,000

-25,000

Change in AP

75,000

-75,000

Change in Interest payable

10,000

-70,000

225,000

225,000

30,000

50,000

Capital expenditures

-220,000

-70,000

Net Cash from Investing

-190,000

-20,000

50,000

-35,000

-95,000

-60,000

Net cash from Financing

15,000

-155,000

Net change in cash

50,000

50,000

Depreciation
Restucturing charge
Loss (Gain) on Sale of assets
Change in AR

Net cash from operations

Proceeds from Sale of equipment

Proceeds from issuance of LT debt

Payment of long-term debt
Dividends paid

Page 40

Analysis of the case. First observation, the Operating Cash Flow (OCF) of
both companies is the same for the two companies, despite the differences
in Net income.
For Purple Inc. we see that they reinvested most of their OCF into long-
term assets. Their Tinancing cash is positive because they needed to raise
some debt to support their expanding activities.
For Green Co., they have the same OCF but they invest almost nothing into
long-term assets, they used all that cash to pay a dividend and paid back
debt. This is a typical example of a lead, mature or declining company.
Next, we are going to take a look at the Operating activities for each
company. Net income for Purple at $150,000 is three times Net income for
Green at $50,000 even if their OCF is actually the same, $225,000. The Tirst
big difference is depreciation; Purple has much less Assets to depreciate
than Green. If we compare to CAPEX, we can see that Purple is in an
Investing cycle whereas Green has only $70,000 of CAPEX, not even
covering its depreciation of $100,000, which again, does not indicate good
prospects for Green.
The next big discrepancy is the restructuring charge; it is not a cash
expense so far and just showed up in the Income statement. It will be paid
cash when actual closures and lay-offs are effective.
Lets take a look at Working capital items. For purple, AR, Inventory and
Accounts payable are increasing, and this is consistent with an increasing
activity. When we look at Green, AR, AP and Inventories are decreasing,
indicating that the growth will be limited for the company.

Page 41

Now lets take a look at the two companies from the EBITDA perspective:

Purple Inc.

Net income
Plus Income taxes
EBT
Plus Interest expenses
EBIT
Plus Dep. and taxes
EBITDA

150,000

50,000

81,000

27,000

231,000

77,000

14,000

13,000

245,000

90,000

50,000

100,000

295,000

190,000

Plus restructuring charge

EBITDA w/o
Restructuring
Adjust for Gains/Loses
EBITDA w/o Restr. & G/L

Green Co.

75,000
295,000

265,000

-10,000

20,000

285,000

285,000

Purple has a much larger EBITDA than Green, which is misleading as we

saw that the two companies have the same Operating cash Tlow.
EBITDARGL is closer to reality, but there is still a difference with Operating
Cash Tlows. There are two reasons for this:
EBITDARGL takes out Interest and Taxes
EBITDARGL does not include the change in Working capital
To get good cash from operations approximation, we can take one of the
two following approach:
Either calculate EBITDARGL and adjust for change in Working
capital
Or take Net cash from operations and add back Interest and taxes
The Statement of Cash Flows was not mandated until 1985. Before that,
there was a confusing "sources and uses statement". So, the Operating
Page 42

Cash Flow number we have today was not always readily available. As a
result, people would use EBITDA as a proxy for operating cash Tlow, and it
has stuck around even since 1985 because it is one of those "we have
always done it that way" measures.

Page 43

CHAPTER 6: WORKING CAPITAL ASSETS

Now that we have a solid grasp of the foundations, we are going to work
our way around the Balance Sheet to discuss various types of Assets,
Liabilities, and Stockholders' Equity (along with their associated Revenues
and Expenses) in more detail. We kick off with Accounts Receivable and
the problem that some customers that buy goods on credit will not
actually pay us. We will look at the computation, disclosure, and analysis
of such "Bad Debts". We will also brieTly discuss other Accounts Receivable
issues such as Factoring and Securitization. Then, we will move on to
Inventory. We will discuss how Inventory accounting differs between
retail and manufacturing Tirms. We will see how companies Tigure out the
cost of the inventory they sold, which requires assumptions about cost
Tlows. This discussion will lead us into covering one of the most infamous
accounting topics: LIFO.

Accounts receivables
As mentioned earlier, revenue is recognized when both earned and realized.
Accounts receivables are created when payment is due after revenue
recognition, but some customers will never pay us. How do we account for
this?
Recognizing Uncollectible accounts. There are two ways to recognize
Uncollectible accounts:
Direct write-off method
o Recognize expense when account deemed uncollectible
o Used for tax reporting, not allowed under GAAP or IFRS
for reporting
Allowance method
o Required under GAAP for Tinancing
o Recognize Bad debt expense for estimated future
Uncollectible amounts from sales during the period
o Create an Allowance for Doubtful accounts (XA) to offset
Accounts receivable on the balance sheet

Page 44

Net A/R = (Gross) A/R Allowance for doubtful accounts (XA)

Accounts receivables work in the same way as the PP&E and depreciation
accounts. We need to book this expense, and not wait for it to happen, to
act accordingly to the matching principle, i.e., expenses are recognized and
the corresponding revenue has been recognized.
Example. BOC makes $10 in sales on account to each of three customers:
Jordan, Dakota, and Peyton.
Cash (A) +Acc. Rec. (A) All. For DA (XA) = Rev. (SE) Exp. (SE) = 30
A/R Ledger Acc. Rec = A/R (Jordan) + A/R (Dakota) + A/R (Payton) = 30
At the end of period, BOC estimates that $10 of sales will not be collected.
We will prepare the following entries:
Dr. Accounts rec. (+A)
$30
Cr. Sales (+R, +SE)

$30
Adjusting entry at the end of the period:
Dr. Bad debt exp. (+E, -SE)
$10
Cr. Allow. for DA (+XA, -A)
$10
In the next period, BOC collects from Jordan and Peyton:
Dr. Cash (+A)

$20
Cr. Accounts rec. (-A)
$20
After 90 days, BOC gives up on collecting from Dakota and writes off the
receivable; the expense has already been recognized, we just need to
decrease the A/R and Allowance for CA accounts:
Dr. Allow. For DA (-XA, +A)
$10
Cr. Accounts rec. (-A)
$10
Finally, we got: Cash (20) + A/R (0) allow. (0) = Rev. (30) Exp. (10)

Page 45

After the write-off, Dakota wins the lottery and pays us $10. First, we need
to restore the allowance and A/R then record the cash collection.
Dr. Accounts rec. (+A)
$10
Cr. Allow. for DA (+XA, -A)
$10
Dr. Cash (+A)

$10
Cr. Acc. receivables (-A )
$10
Estimating Uncollectible accounts. There are two basic allowance
methods to calculate bad debt expenses:
Percentage of sales method:
o Estimates Bad debt expenses directly
o Multiply (credit) sales by an estimated uncollectible
percentage to compute Bad debt expense
o Plug in T-accounts to solve for the ending balance of
Allowance for doubtful accounts.
Aging of accounts receivable method:
o Estimates ending balance of Allowance for doubtful
accounts directly
o Multiply Balance sheet A/R amounts by estimated
uncollectible percentages, based on how long the A/R has
been outstanding, to compute ending balance of
Allowance for doubtful accounts
o Plug in T-account to solve for Bad debt expense
Companies can choose what method to use to get an accurate estimate of
uncollectible sales. Lets say that BOC had sales on credit for $75,000, then
$69,500 of cash collections and a write-off of $500.
Percentage of sales method. BOC had credit sales of $75,000 during the
quarter, and they estimate that 2% of credit sales will be uncollectible.
Bad debt expense = Credit sales x Estimated uncollectible %
Bad debt expense = 75,000 x 0.02 = $1,500
The percentage of bad debt is determined by three factors, the history of
bad debt in the company, the industry benchmark, and what the company
thinks the future will be.
Page 46

The journal entries for these operations would be the following. First we
book the credit sales to the Accounts receivables:
Dr. Accounts rec. (+A)
$75,000
Cr. Sales (+R, +SE)

$75,000
Then, we prepare this entry for the write-off of $500:
Dr. Allow. For DA (XA)
$500
Cr. Acc. receivables (-A )
$500
Finally, we will write the following entry for the bad debt expense:
Dr. Bad debt exp. (+E, -SE)
$1,500
Cr. Allow. For DA (+XA, -A)
$1,500
Ageing of accounts receivable method. This time, BOC will have to
group the A/R by age, i.e., time outstanding and estimate an uncollectible
percentage for each age group.

A/R bal.

Estimated
Uncoll. %

Allow.

0-30 days

8,000

5%

400

31-60 days

4,000

10%

400

61-90 days

2,000

30%

600

Over 90 days

1,000

50%

500

Total

1900

The two Tirst journal entries are the same as before, the only change will
be the amount of the allowance for the third journal entry will be different:
Dr. Bad debt exp. (+E, -SE)
$1,900
Cr. Allow. For DA (+XA, -A)
$1,900
Therefore, the ending balance for Allowance for doubtful account will be
different under the two methods. It does not really matter because it is an
estimate and nobody can know what the future will really look like.
A/R and the Statement of cash 9low. Cash collections of A/R are
Operating cash Tlow, but Bad debt expense, Write-offs and Recoveries are
noncash transactions.
Page 47

There are two methods for Bad debt expense reallocation in the Operating
cash Tlow statement:
Add back Bad expense, net of Write-offs and Recoveries, then add
or subtract change in Gross A/R
Add or subtract change in Net A/R
Method 1

Method 2

Cash from Operating activities

Cash from Operating activities

Net income

Net income

+ Net Bad debt expense

+/- Change in gross A/R

+/- Change in Net A/R

Cash Tlow from Operations

Cash Tlow from Operations

Companies have the choice between the two methods, so that they can
inform investors and stakeholders. If Bad debt is not signiTicant, a
company might prefer method 2 in order to save some space.
Methods to collect cash from A/R more quickly. The Tirst method is
pledging A/R as collateral for a loan, the Tirm retains the A/R and the risk
of collection, which they may not want to do.
The second method is factoring, where the company sells the A/R to a
Tinancial institution at a discount that reTlects an interest charge and the
risk of uncollectibility. The longer the receivables, the higher the discount
will be applied.
For longer receivables, the company can sell its A/R to a separate legal
entity, called a Variable Interest Entity, created for the exclusive purpose of
securitizing receivables. The VIE borrows money from investors and then
uses the proceeds to buy the A/R from its parent. This is what we call
securitization.
Accounts receivable disclosure example: real examples with fake
names. TK Inc. sells coin wrappers to the banking industry, it had sales for
the year ended Dec. 31, 2008 of $149,270,000. We will use excerpts from

Page 48

the Balance sheet and the Statement of cash Tlows to answer the following
questions:
What were write-offs of A/R in 2008?
What were cash collections from customers in 2008?
By how much did a change in the estimated uncollectible
percentage affect bad debt expense in 2008?

Net income

2008

2007

2006

926

2,518

1,641

Adj. to reconcile Net income to net cash from operating activities

Depreciation and amortization

6,626

4,391

2,357

Loss on disposal of Tixed assets

972

863

278

Provision for doubtful accounts

1,558

325

203

Deferred income tax

(189)

(585)

363

Receivables

(6,662)

(2,873)

(356)

Inventories

(1,526)

(3,701)

(663)

(707)

494

(559)

Accounts payable

(4,922)

3,709

326

Accrued expenses

1,185

287

543

(2,739)

5,426

4,133

Changes in assets and liabilities

Other current assets

Net cash from operating activities

We can see Tirst that something big is going on with their receivables as
the A/R are increasing at a very rapid pace.

Page 49

Current assets at December 31,

2008

2007

Cash and cash equivalents

2,098

1,576

of $1021 in 2008 and $220 in 2007

12,930

7,826

Inventories

15,217

9,926

1,320

606

500

108

2,376

1,644

34,441

21,689

Accounts receivable, less allowance

Other current assets

Loans to ofTicers
Deferred incomes taxes, net
Total current assets

From these data, we will try to Tind the write-offs.

Allowance for Doubtful accounts (XA)
220 12/31/2007
1,558 Bad debt ex.
Write-offs? 757
1,021

Write-offs = Beg. bal. of DA + Bad debt exp. End. Balance

Write-offs = 757
Now, we try to Tind what were cash collections in 2008. Notes:
Sales for 2008 were $149,270
Beginning balance A/R (Gross) = 7,826 + 220 = 8,046
Ending balance A/R (Gross) = 12,930 + 1,021 = 13,951
Accounts receivable (A)
12/31/2007 8,046
Sales 149,270 142,608 Collections?
757 Write-offs
13,951

Page 50

Companies usually do not disclose their collections during the year, so it

has to be calculated. Note that the difference between Sales and
Collections is the increase in A/R, 6,662.
Uncovering a change in Bad debt expense. We need Tirst to compute the
percentage of Gross Accounts receivable that are expected to be
uncollectible in prior year.
Percent uncollectible = Allowance / (Net AR + Allowance)
Then, we apply this percentage to balance of Gross A/R in current year to
get the expected balance.
Expected Bal. of allowance = % uncollectible x (Net AR + Allowance)
Expected allowance @ 2.7% in 2008 = 13,951 x 2.7% = 377
Expected allowance @ 7.3% in 2007 = 8,046 x 7.3% = 587
Finally. The change in expense due to change in bad debt assumptions is
the actual balance in Allowance minus expected balance. It therefore
appears that TK understated its Alowance in 2007 by $367. The
percentage of bad debt can be manipulated to improve the income
statement, by lowering its expected percentage of Bad debt expense.
Which might be the case here, but is might as well be an honest mistake
considering the Tinancial system situation in 2007 2008.
Still, this calculation can help uncover some manipulations.
Inventory
We are now turning our attention to inventory, and especially to the
inventory of a manufacturing Tirm, which is more complicated than what
we have seen so far, i.e., a retail Tirm.

Page 51

Payables or cash
Purchases

Inventory
Purchases

Cost of goods Sold

Goods sold

Goods sold

Cost of goods Sold

Selling costs

Selling costs

Admin costs

Admin costs

In a manufacturing company, we would have three intermediary accounts

in place of the inventory account, Raw materials, Work in progress and
Finished goods.
Payables or cash

Raw materials

Purchases

Cost of goods Sold

Goods sold

Work in process

Finished Goods

Cost of goods Sold

Selling costs

Selling costs

Admin costs

Admin costs

Lets take the example of Kirby Manufacturing. Kirby purchased $865 of

raw materials on account.
Dr. Raw materials (+A)
$865
Cr. Acc. Receivables (+L)
$865
Page 52

Kirby used $806 of Raw materials inventory in manufacturing.

Dr. Work in process (+A)
$806
Cr. Raw materials (-A)
$806
Other things will come into account in Work in process, Direct labor and
Overhead. Kirby paid $524 cash for manufacturing labor.
Dr. Work in process (+A)
$524
Cr. Cash (-A)

$524

Kirby paid $423 cash for power, heat, light and other overhead.
Dr. Work in process (+A)
$423
Cr. Cash (-A)

$423
Kirby recognized $81 of depreciation for plant equipment. The
depreciation of the factory is a product cost.
Dr. Work in process (+A)
$81
Cr. Acc. Depreciation (+XA)
$81
Kirby Tinished manufacturing goods that cost $1,960.
Dr. Finished goods (+A)
$1960
Cr. Work in process (-A) $1960
Kirby sold $2,862 of goods to customers on account, the goods cost $1,938
to manufacture.
Dr. Acc. receivables (+A)
$2,862
Cr. Revenue (+R, +SE) $2,862
Dr. COGS (+E, -SE)

$1,938
Cr. Finished goods (-A) $1,938
Inventory and COGS. The question left now is how do we know the Cost
of good sold vs the cost of the goods that we still have in inventory? We
can use the following equation to look at this question:
Beg. inventory + New inventory = COGS + Ending inventory

Page 53

We know Beg. inventory and New inventory, but not COGS and Ending
inventory.
New inventory can be:
For a retail Tirm, the cost of purchasing goods
For a manufacturing Tirm, new inventory is the cost of producing
goods.
But we need an assumption to determine what goes to Inventory and what
goes to COGS. There are two methods for this:
Periodic system: count Ending inventory and plug COGS
Perpetual system: track COGS as sales are made and plug Ending
inventory
To track COGS is not an easy task and requires some assumptions, and
anyway, every company needs to prepare an inventory at least once every
year to account for possible theft.
Inventory valuation: Lower of cost or market. The ending balance of
Inventory must be carried at the lower of historical cost or fair market
value:
Historical cost is the original cost of purchasing or producing the
inventory
Fair market value is generally the replacement cost of the
inventory.
Management is responsible to come with a fair market value assumption.
If the fair value has dropped under the historical cost, the company has to
take a write-off:
If Cost < FMV, Ending inventory = Original cost, then no adjusting entry is
needed
If FMV < Cost, Ending inventory = Replacement value, we need an
adjusting entry to write-down inventory.
Dr. COGS (+E, -SE)
Cr. Inventory (-A)

Page 54

A key international difference is that under US GAAP, once inventory is

written down to FMV, it cannot be later written back up to original cost if
the market value subsequently rises.
Under IFRS, inventory can be written up subsequent to a write-down, but
only back to the original cost.
LIFO and FIFO. We have to start with a key assumption: Inventory cost
Tlows do not have to follow physical Tlow of goods. Concerning the physical
Tlow of goods, goods in inventory are whatever speciTic goods that we
havent sold yet (normally the newest goods).
But for the Tlow of cost, the costs in Ending inventory could (1) match the
original cost of the goods, (2) be the most recent costs incurred, (3) be the
oldest costs incurred, or (4) be an average of costs over time.
Review of the four methods of inventory cost Tlow assumptions. We eill
now look closer at these methods:
SpeciIic identiIication speciTically identiTies the cost of each
product sold. This method is not suitable for non-discreet goods
like toothpaste and liquids; but even for other products, keeping
track of all the costs for each individual goods is impossible.
FIFO (First In First Out) in which the oldest inventory costs go to
COGS Tirst, and Ending inventory has the latest costs
LIFO (Last In First Out) where the newest inventory costs go in
COGS Tirst, so that the Ending inventory has the oldest costs
Weighted average, the average cost of all inventory goes into
COGS and ending inventory. In practice, it gives very similar
results to FIFO
Example. We buy Tive units at different times during 2010, and we sell
three.
Costs 2010
FIFO
LIFO

Jan $10

Mar $15

Jun $20

COGS: $45
End inventory: $25

Sep $25

End inventory: $55

COGS: $75

Page 55

Dec $30

FIFO = LISH = Last In Still Here

LIFO = FISH = First In Still Here
Under LIFO, the company has a higher COGS, as the cost of buying units
increases. For the next period, the company using FIFO will have a higher
beginning inventory.
Costs 2011

Beg. inventory

FIFO

$55

$35

LIFO

$25

$35

$40

$45

$40

$45

With FIFO, if we sell 3 units in 2011, we will have a COGS of $90 and an
End. inventory of $85. For LIFO, if we sell 3 units, the COGS will be $120
and the End. Inventory will still be $25.

Costs 2012
FIFO

Beg. inventory

LIFO

$40

$45

$10

$15

In 2012, we sell 2 units and liquidate the business. The low LIFO COGS in
2012 is due to dipping into old LIFO layers of inventory. This called a
LIFO liquidation and must be disclosed due to its dramatic effect on
COGS and Net income. Summary of COGS:
FIFO

LIFO

$45

$75

2011

$90

$120

2012

$85

$25

Totals

$220

$220

2010

LIFO vs FIFO changes the timing of COGS, but over the life of the Tirm total
COGS are the same.
Page 56

Why does it matter whether 9irms use FIFO or LIFO? When inventory
costs are rising, COGS under LIFO is higher and Ending inventory under
LIFO is lower as compared to FIFO.
In the US, tax reporting allows LIFO, so high LIFO COGS, will give a lower
Taxable income and lower taxes paid. But, if a Tirm uses LIFO for taxes, it
must use LIFO for Tinancial statements.
From the previous example, we would have a lower taxable income the
two Tirst years (-30) and a higher for 2012 (+60). At the tax rate of 35%,
we would save $10.5 in taxes the Tirst two years and then pay an extra $21
the last year.
IFRS does not permit the use of LIFO, US is the only major country that still
allows LIFO.
Compare a FIFO 9irm and a LIFO 9irm. A LIFO Tirm must always disclose
FIFO inventory costs, we can convert LIFO to FIFO, but we cant convert
FIFO to LIFO.
LIFO reserve = FIFO End inventory LIFO End inventory
LIFO reserve = LIFO COGS FIFO COGS
FIFO COGS = LIFO COGS - LIFO reserve
FIFO Net income = LIFO Net income + LIFO reserve x (1-tax rate)
Tax savings (current year) = LIFO reserve x tax rate
Tax savings (cumulative) = LIFO reserve x tax rate
Example. KP Inc. manufactures Tlux capacitors and uses LIFO method.
COGS for KP are $1855 for 2012. KP tax rate is 35%. What is the FIFO
value of the inventory? What would be FIFO COGS in 2012? What were
2012 tax savings?

Page 57

Note 11: Inv.

2012

2011

Raw materials

153

147

Work in process

217

203

Finished goods

250

253

620

603

Less revaluation to LIFO

(102)

(63)

LIFO values of inventory

518

540

FIFO inv. 2012 = LIFO res. + LIFO inv. = 518 + 102 = 620
FIFO inv. 2011 = 540 + 63 = 603
FIFO COGS = LIFO COGS - LIFO reserve = 1855 (102 63) = 1816
Tax saving = LIFO reserve x tax rate = (102 63) x 0.35 = 13.65

Page 58

CHAPTER 7: RATIO ANALYSIS

In this chapter, we will review a lot of the materials that we studied before
in the previous chapters. We will review the Dupont analysis in details,
then the liquidity ratios.
Using ratios. Ratios are useful in assessing proTitability, liquidity and risk,
they will help us highlight sources of competitive advantage and red
Tlagpotential trouble.
Ratios must be compared to a benchmark and compare:
the same Tirm across time (time series analysis)
the Tirm to other Tirms or to industry (cross-sectional analysis)
Ratios are contextual, we need to try to determine the underlying activity
that the ration represents to determine whether it is good or bad news.
Ratio analysis does not provide answers, but instead helps you ask
better questions.
Misusing rations. Standard ratios have multiple deIinitions; there is no
GAAP for ratio deTinition so we need to use the same deTinition to make
valid comparisons. Also, choosing the appropriate benchmark for
comparison is important as major changes in the Tirm distort time-series
analysis, differences in business strategy, capital structure, or business
segments distort cross-sectional analysis, and Tinally, differences in
accounting methods make all comparisons difTicult.
For example, if a software company buys a hardware company, the time
series analysis will be distorted by the change in business scope. Similarly,
companies with different inventory methods, like LIFO and FIFO, will not
be readily comparable because of the differences in accounting methods
used.
Ratios can be manipulated by managerial action, if management notices
that investors focus on certain ratios, they may take actions to please them
without really improving the company fundamentals.

Page 59

The Dupont ratios

Return On Equity. Is a net income of $10,000,000 good or bad? To get a
good answer to this question, we must know how much has been invested
to produce this Net income result. It measures the return on investment,
so it should increase with the risk of the company.
Return On Equity = Net income / Average Shareholders Equity
The numerator represents how much return the company generated for
shareholders during the year based on accrual accounting.
The denominator represents the shareholders investment in the company,
so we must take the average of beginning and ending balances.
The drivers of the ROE are:
Operating performance, which answers the question How
effectively do managers use company resources (assets) to
generate proTits? Return on Assets (ROA) = Net income / average
Assets
Financial leverage, which answers the question How much do the
managers use debt to increase available assets for a given level of
shareholder investment? Financial leverage = average Assets /
Average Shareholders Equity
The ROE basic framework:

Page 60

Example. A company raises $100 from shareholders and borrows $100

from bank to buy $200 of assets, which are used to generate $10 of net
income.
ROE = 10% (10/100)
ROA = 5% (10/200)
Leverage = 2 (200/100)
We can now go more in details for the ROA. There are two drivers of
Return on Assets:
ProTitability
How much proTit does the company earn on each
dollar of sales
Return On Sales (ROS) = Net income / Sales
EfTiciency
How much sales does the company generate on its
available resources
Asset turnover (ATO) = Sales / Avg. Assets
The Dupont analysis framework:

Ideally, ROA would measure operating performance independent of the

companys Tinancing decisions, but the numerator of ROA, Net income,
includes Interest expense, so we need to de-lever the ROA.

Page 61

ROA = Delevered Net income / Avg. Assets

De-levered = Net income + (1 - t) x Interest expense
Example of two companies
No debt (cpy A)
Pretax , pre-interest income

Some debt (cpy B)

300

300

(50)

300

250

(105)

(87.5)

195

162.5

Interest expense
Pretax income
Taxes (35%)
Net income

To compare these two companies, we need to de-lever company B Net

income: DL NI = 162.5 + (1 - 35%) x 50 = 195. Therefore, the two
companies have the same de-levered Net income.
To summarize:
ROE = (NI/Sales) x (Sales/Assets) x (Assets/Equity)
For each ratio, we break down the ratio analysis even further:

Page 62

Liquidity ratios. We will take a look at the liquidity ratios that we use to
see if a company have enough assets to covers its obligations.

Short-term liquidity ratios. It tries to answer the question: Does the

company have enough cash coming in to cover obligations to pay out cash?
Ideally, ratios would be over 1, i.e., the company have enough cash to pay
its short-term obligations. The Current ratio:

Current ratio = Current Assets / Current Liabilities

Current assets, are the assets that are going to turn into cash in the coming
year, vs current liabilities, i.e. the obligations to pay in the same coming
year. A drawback of the Current ratio is that not all Currents assets are
going to turn into cash (Prepaid cash, Prepaid rent), and some are not
really liquid, like inventory.
So, a safer ratio is the Quick ratio which is calculated as follow:

Quick ratio = (Cash + Receivables) / Current Liabilities

This one is generally a little less than 1, as it is much harder to get over 1.
Next, we have the CFO to Current liabilities ratio:

CFO to Current Liab. = CFO / Avg. Current liabilities

Page 63

Interest coverage ratios. Does the company have enough cash coming in
from operations to cover interest obligations? Same here, ideally, ratios
should be over 1. First ratio, Interest coverage:

Int. coverage = (Operating Inc. before Dep.) / Interest expense

And then, another one:

Cash Int. Coverage = (CFO + Cash interest paid + Cash tax) / Cash
Int. paid
Long-term debt ratios. How does the company Tinance its growth? It also
provide a measure of bankruptcy risk. Debt to equity:
Debt to Equity = Total liabilities / Shareholders equity
Total assets is sometimes used in the denominator. Then we have:

Long-term Debt to Equity = Total LT Debt / Total SE

LT Debt to Tangible assets = Total LT Debt / (Assets - Int. assets)

Page 64

CHAPTER 8: LONG-LIVED ASSETS AND MARKETABLE

SECURITIES
In this chapter, we will cover assets that represent longer-term
investments. We will start with Property, Plant, and Equipment, covering
questions like: What gets included in these accounts? How are they
depreciated? What happens if their value is impaired? Then, we will cover
similar questions for Intangible Assets, including Goodwill. Finally, we will
discuss how companies account for investments in debt and equity
securities and how the treatment for equity investments in other
companies is determined by how much of the other company is owned.

Long-lived assets
A long-lived asset is an asset that will provide beneIits for more than one
year like:
Tangible assets: Property, Plant, and Equipment
Intangible assets: Goodwill, Brand names, Patents, and Customer
lists.
We will look at accounting issues that arise when dealing with long-lived
assets:
What happens when we acquire a long-lived asset
How depreciate or amortize it
What happens when we spend money on an asset
What do we do when we dispose of a long-lived asset
What happens when the value of the asset is impaired
Note about Capitalizing vs Expensing a cost. When we capitalise a cost,
we create an asset corresponding to the cash expense or the increase in
payables. When the cost incur, we do the prepare the following entry:
Dr. Assets (+A)

$100
Cr. Cash or Payables (-A or +L))
$100

Page 65

Then, for future entries, we will take some expenses out of the Assets
account, here from year 1 to 10:
Dr. Expense (+E, -SE)

$10
Cr. Assets (-A)


$10
When we talk about expensing a cost, we take the same cost and recognize
the full expense immediately:
Dr. Expense (+E, -SE)

$100
Cr. Cash or Payables (-A or +L))
$100
Over 10 years, the expense is the same, it just changes the time the
expense will hit the income statement.

Long-lived assets: Tangible assets

Acquisition costs for Ling-lived assets. We will capitalise all costs
necessary to get an asset ready for its intended use, e.g., purchase price,
delivery charges, installation cost, etc.
For self-constructed assets, we also capitalise interest on debt that is
incurred to Tinance the assets construction. In this case, interest expense
on the income statement does not reTlect all of the interest costs incurred
by the Tirm.
If acquisition costs include multiple classes of assets, e.g. land, building,
and machinery, the cost must be allocated into separate asset classes.
Example. Bott Inc. builds a new piece of equipment to put grips on golf
clubs. Bott spends $4,500 on Raw materials and $3,000 cash on labor. Bott
incurs $500 of interests costs (interest payable) to Tinance the building of
the equipment.
(1)Dr. Equipment (+A)
Cr. Cash (-A)

Cr. Interest Payable (+L)

Page 66

$8,000

$7,500

$500

Reminder. Tangible assets are depreciated and Intangible assets are

depreciated. The depreciation basis is (acquisition - salvage value) and the
useful life can be in years or units. The depreciation pattern can be a
straight line or an accelerated method. All of this elements are chosen by
management, they make their best estimate.
Straight line depreciation is the most common method used in Tinancial
statements: Dep. Exp. = (Acquisition cost - Salvage value) / Useful life
Accelerated method is almost never used in Tinancial statements. Methods
used include the
Double declining balance: Dep. Exp. = (Cost - Acm. Dep.) x (2 /
Useful life)
Sum of the years digits method: Dep. Exp. = (Cost - Salvage) x
(Remaining life (Sum of the years digits).
Another method is required in US tax returns, the MACRS method,
which is very speciTic
Regardless of the method used, the total depreciation expense is the same
over the life of the asset. Illustration:

Page 67

Back to the example. Bott management decides that the equipment will
have a useful life of six years with a $2,000 salvage value. Bott must
recognize one year of depreciation using the straight-line method.
The recognised asset was worth $8,000, so the one-year depreciation
expense for this asset will be:
Dep. Exp. = (8,000 - 2,000) / 6 = $1,000
Bott management estimates that 3/4 of the time the equipment was used
to produce golf club inventory; the rest of the time it was used for the
personal clubs of the sales force and top management, which is a perk that
Bott provides these employees.
(2)Dr. Work in process (+A)
Dr. Depreciation exp. (+E)
Cr. Acc. Dep. (+XA)

$750
$250

$1,000

Ongoing costs for long-lived assets. We should expense these costs when
they are related to the maintenance of an asset. We should capitalise costs
when these costs:
Increase the useful life of the asset or
Increase the value of the asset
These capitalised costs will add future depreciation expense, so we need
to:
Adjust the useful life and salvage value assumptions
Recompute depreciation expense going forward
Use the Net book value as new historical cost of asset
Example. Bott spends $200 on routine maintenance for the equipment.
(3)Dr. Maintenance expense (+E) $200
Cr. Cash (-A)


$200
Note: this maintenance expense will be split between Work in process
inventory (75%) ans SG & A expense (25%).

Page 68

Bott spends $600 on new attachement to the equipment that will allow if
to add grips to the new style of extra-long putter.
(4)Dr. Equipment (+A)
$600
Cr. Cash (-A)


$600
Bott management decides that the new attachement has increased the
useful life to ten years (going forward) with salvage value of $600. Bott
must recognize one more year of depreciation.
New annual del. = ((8,000 - 1,000) + 600 - 600) / 10 = $700
Bott management estimates that 100% of the time the equipment was
used to produce golf club inventory (much of the dismay of its employee
with extra-long putter)
(5)Dr. Work in process (+A)
$700
Cr. Acc. dep. (+XA, -A)

$700
Disposal of PP&E. If we want to get rid of an asset before the end of its
useful life, the historical cost of the asset is removed from PP&E account
and all related depreciation is removed from Accumulated depreciation.
Then gain or loss on the sale of PP&E is recorded when the proceeds from
disposal are more or less than the net book value, respectively.

Page 69

Net Book value = historical cost - accumulated depreciation

The journal entry will look like this:
Dr. cash (+A)


Dr. Acc. Dep. (-XA, +A)
Dr. Loss on sale (+E, -SE)
Cr. Gain on sale (+R, +SE)
Cr. SpeciIic PPE. (-A)

(sale amount)
(full balance)
(if Net book value > cash)

(if cash < NBV)

(historical cost)

Bott is in Tinancial distress due to high employee turnover. Bott decides to

subcontract the grip work, so it sells its piece of equipment for $5,500.
Dr. cash (+A)


$5,500
Dr. Acc. Dep. (-XA, +A)
$1,700
Dr. Loss on sale (+E, -SE)
$1,400
Cr. Equipment (-A)

$8,600
Impairment tests. Long-lived assets must be written down if they fail an
impairment test:

Step 1: Have circumstances changed that rais e the possibility of an

impairment?

Step 2: Are the future undiscounted net cash Tlows from the asset
(from use or sale) less than its net book value

Step 3: Write-down the book value of the asset (and record a loss)
equal to the difference between the fair value of the asset and its
net book value

Example. In an alternate reality, Bott keeps the equipment but Tinds that it
has been impaired due to employee sabotage. Bott management estimates
that the fair market value of the equipment is now $5,500.
Dr. Equipment (+A)

$5,500
Dr. Acc. Dep. (-XA, +A)
$1,700
Dr. Impairment loss(+E, -SE)
$1,400
Cr. Equipment (-A)

$8,600

Page 70

International differences for Long-lived assets.

Carrying value:

US GAAP requires the lower-of-cost-or-market with depreciation

expense recorded each period

IFRS: allows lower-of-cost-or-market method of fair value method.

Under fair value method, PP&E is carried at fair value at all times,
with any unrealised gains or losses either Tlowing through the
income statement or directly to stockholders equity

Impairment:

US GAAP: Assets written down cannot be written back up in value

at a later date

IFRS: Under lower-of-cost-or-market, assets written down can be

written back up to the original cost of the asset (less accumulated
depreciation). Also, determination of whether an impairment is
necessary is initially based on the discounted present value of cash
Tlows.

Intangible assets and goodwill

In general, US GAAP and IFRS require that internally developed intangibles
have to be expensed immediately (R&D, Advertising, Employee training).
However, some types of R&D can be capitalised:
US GAAP: Software
IFRS: Development
Both systems require that purchased intangibles have to be capitalised as
an asset, such as purchased patents, Trademarks, Customer lists and
Goodwill.
Purchased intangibles are usually added in an acquisition. Intangible
assets and liabilities must be separately recognised if:
Page 71

 The intangible arises a transferable contract or

The intangible asset is separable
Non-separable intangibles are included in Goodwill.
Intangible assets with a deTinite life must be amortised over that life like
Patents, Copyrights and Customer lists.
Intangible with an indeTinite life are not amortised, examples include
Brand names and Goodwill.
BUT Intangible assets are still subject to the usual asset impairment tests.
Goodwill. When an acquirer purchases a target Tirm, the targets
individual assets and liabilities are Tirst adjusted to reTlect their current
market values. Then the acquirer records any separable or transferable
intangible assets. Finally, Goodwill equals the excess of the purchase price
over the market value of net identiTiable assets.
Example. KP acquired TK for $2,000,000 cash; TK balance sheet and KP
estimates for fair values are shown below:

Page 72

The accounts will be carried by the acquirer at the Estimated fair value,
and Stockholders equity will disappear. Furthermore, KP estimates that it
acquired a customer list worth $200,000 and a proprietary technology
worth $500,000. KP must record the acquisition using fair values and
adding any intangibles acquired. Journal entry:
Dr. cash (+A)


$2
Dr. Acc. Rec. (+A)

$80
Dr. Inventory (+A)

$78
Dr. Net PP&E (+A)

$900
Dr. Customer List(+A)
$200
Dr. Prop. tech. (+A)

$500
Dr. Goodwill (+A)

$440
Cr. Payables (+L)

$170
Cr. Other liabilities (+L)

$30
Cr. Cash (-A)


$2,000
Disclosure example. Lyons Inc. manufactures hurlers, the sticks used in
the sport Hurling. In 2008, Lyons acquired Finch Corp., but the acquisition
did not work out and Lyons took a Goodwill impairment charge in 2012.
We will use Lyons footnote disclosures to answer the following questions:
About PP&E
o What is the historical cost of Lyons PP&E?
o How much new PP&E did the company acquire during
2012?
o What is the historical cost of the PP&E sold during 2012?

For intangibles:
o How many years does Lyons have left before its Patents
expire?

Page 73

o How did the Goodwill impairment affect Lyons Tinancial

statements and ratios in 2012?

First question, about the historical PP&E. On the balance sheet, we just
have the net PP&E, we need to take a look at footnote 7:

We get the answer to our question, historical PP&E was 768.5 in 2011 and
825.1 in 2012. Note that although land is included here, it is never
depreciated. Also, the range of estimated useful lives is too large, the
company should be more speciTic.
Page 74

Now, we get to answer how much PP&E was acquired in 2012. Lets take a
look at their Investing statement of cash Tlows.

Cash CAPEX was 29.4, non cash CAPEX was 41.2 for a total of 70.6 total
acquired. To determine the historical cost of PP&E sold in 2012, we need
to take a look at the T-accounts:

To balance the T-account of PP&E, Lyons must have sold 14 million of

PP&E (or an impairment of PPE). Now, we will try to do the Journal entry
for this transaction. But Tirst , we also need to look at the Operating
Statement of cash Tlows to see if we recorded some loss or gain on the
sales of assets in 2012:

Page 75

The journal entry is the following:

Dr. cash (+A)


Dr. Acc. Dep. (-XA, +A)
Dr. Loss on sale (+E, -SE)
Cr. PPE (-A)

$8.8
$5.0
$0.2

$14

Now, we will recreate the Accumulated depreciation T-account:

To balance this T-account, we need to have a 63.2 million of Depreciation

expense this year.
On goodwill, to know how much of the patents have been already
amortized, we will now turn to the footnote on Goodwill:
Page 76

So 5.6 years have been used up as the total life of patents is 16 years.
There is no salvage value for patents, we assume that the salvage value is
zero.
The Goodwill has been impaired by 285.3 million, so we prepare the
following journal entry:
Dr. Loss (+E, -SE)

$285.3
Cr. Goodwill (-A)


$285.3
Referring to the Operating SCF, we can see that there was a net loss on
Income statement that was due to the impairment charge. But it had no
impact on Cash from operations (or EBITDA). Also, the assets drop in 2012
is due to the impairment and all ratios will be affected by this drop.

Marketable securities
Marketable securities are stock or debt invested in other companies, their
accounting treatment depends on inTluence and intent.
Small investments in equity (less than 20%) or investments in debt
o Marketable securities (A)
o Three methods: Trading, Available for sale, and Held to
maturity (debt only)
Strategic investment in equity (20% to 50% or signiIicant inIluence)
o Investment in AfTiliates (A)
o Two methods: Equity method or Fair value accounting
Control investment (greater than 50%)
o One method: full consolidation
o Add all assets, liabilities, income of other company,
recognise noncontrolling interest
We will discuss only of small investments in equity, Marketable
securities. Market securities are equity investment of less than 20%
ownership in another Tirm, they are treated based on the intent"in
making the investment. Categories are the following:
Trading securities

Page 77

o Intent is to proTit from short-term Tluctuations in market

prices (active management)
o Common in Tinancial services Tirms and Tinancial services
divisions
Available-for-Sales (AFS)
o Intent is to earn returns over the medium to long-term
(invest cash until needed for new project)
o Common in non-Tinancial companies
Held-to-maturity (HTM): debt investments can be accounted for as
trading, AFS, or Held-to-maturity securities.
o Firm has both the ability and intent to hold the debt
investment until it matures
o Do not mark-to-market
o Recognize interest revenue each period

Trading vs AFS. On the balance sheet, both methods the investment is

carried at fair value at the balance sheet date (mark-to-market), this
mark-to-market creates unrealised gains or losses.
The difference is on the Income statement:
Trading: Unrealized gains or losses go on the Income statement
AFS: Unrealized gains or losses go into Accumulated other
comprehensive income (AOCI),
o AOCI is like a Retained earnings account, except that
transactions go directly into AOCI without appearing on
the Income statement.
o AOCI stores up unrealised gains or losses until security is
sold, when they are reversed out into the Income
statement.
o Key disclaimer: transactions go into AOCI net of taxes, but
we are going to ignore taxes for this topic.
Example. Bott bank buys $100 of TK stock, which is less than 20%
ownership, and decides to classify it as a Trading security. Journal entry:
Dr. Marketable securities (+A)

$100
Cr. Cash (-A)



$100

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Meyer Co. buys $100 of TK stock, which is less than 20% ownership, and
decides to classify it as an AFS security. Journal entry:
Dr. Marketable securities (+A)

$100
Cr. Cash (-A)



$100
No difference here. Then both companies receive $5 of dividends from TK
stock. They both get the same journal entry also:
Dr. Cash (+A)


$5
Cr. Dividend revenue (+R, +SE)

$5
At quarter end, Bott bank investment in TK stock is now worth $103.
Journal entry:
Dr. Marketable securities (+A)

$3
Cr. Gain on investment (+R, +SE)

$3
At quarter end, Meyer Co. investment in TK stock is now worth $103.
Journal entry:
Dr. Marketable securities (+A)

$3
Cr. AOCI (+SE)



$3
Unrealized gain is part of Net income for Trading (Bott) and bypasses the
Net income for AFS (Meyer).
After quarter end, Bott sells its TK stock for $101. Journal entry:
Dr. Cash (+A)


$101
Dr. Loss on investment (+E, -SE)
$2
Cr. Marketable securities (-A)

$103
After quarter end, Meyer Co. sells its TK stock for $101. Journal entry:
Dr. Cash (+A)


$101
Dr. AOCI (-SE)


$3
Cr. Gain on investment (+R, +SE)

$1
Cr. Marketable securities (-A)

$103
Realized gain or loss based on last balance sheet value (103) for Trading
(Bott) and based on original cost (100) for AFS (Meyer).

Page 79

Now, imagine the price drops. Mark-to-market on the balance sheet date.
At quarter end, Bott banks investment in TK stock is now worth $97.
Journal entry:
Dr. Loss on investment (+E, -SE)
$3
Cr. Marketable securities (-A)

$3
At quarter end, Meyer Co. investment in TK stock is now worth $97.
Journal entry.
Dr. AOCI (-SE)


$3
Cr. Marketable securities (-A)

$3
Unrealized loss is part of Net income for Bott but not for Meyer.
After quarter end, Bott bank sells its TK stock for $101. Journal entry:
Dr. Cash (+A)


$101
Cr. Gain on investment (+R, +SE)

$4
Cr. Marketable securities (-A)

$97
After quarter end, Meyer Co sells its TK stock for $101. Journal entry:
Dr. Cash (+A)


$101
Cr. Gain on investment (+R, +SE)

$1
Cr. AOCI (+SE)



$3
Cr. Marketable securities (-A)

$97
Realized gain is based on last balance sheet value (97) for Trading (Bott)
and based on original cost (100) for AFS (Meyer).
Note. Taxes are paid only on realised gains or losses, so both companies
will pay the same amount of tax. We will see that later in the Deferred
taxes chapter.

Page 80

Now, we will review a summary of the Bott (Trading) vs Meyer (AFS) case:
Held-to-maturity securities. Acquisition journal entry:

Dr. Marketable securities (+A)

Cr. Cash (-A)

When interests are paid:

Dr. Cash (+A)


Cr. Interest revenue (+R, +SE)

$100

$100

$5

$5

Change in Fair value at period end do not impact the Financial statements.
When the security is sold:
Dr. Cash (+A)


Cr. Gain on investment (+R, +SE)
Cr. Marketable securities (-A)

$103

$3
$100

SCF effects of Marketable securities. In the case of Trading securities, it

will show in Operating activities, add decreases (or subtract increases) in
balance sheet account in Cash Tlow from Operations section.
Available-for-sale and Held-to-maturity securities will show up in Investing
activities, cash for purchases and from sales is listed in the Cash Tlow from
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Investing activities. Add back realised losses (or subtract realised gains) in
Cash Tlow from Operations section.
Marketable securities disclosure. BOC Automotive has a Tinancial services
segment that helps its customers Tinance the purchase of cars. As a part of
its business, this segment invests in marketable securities. We will use
BOCA footnote disclosures to answer the following questions:
What is the cost, fair value, and book value (i.e., balance sheet
value) of BOCAs marketable securities as of 12/31/2012?
What are the accumulated unrealised gains and losses as of
12/31/2012? Where have they been recognised?
Did BOCA recognize gains or losses from selling securities during
2012? What was the book value of securities sold by BOCA during
2012?
Could BOCA have increased its pre-tax income in 2012 through
changes in how it managed its marketable securities?

Page 82

Often, companies will not disclose their Trading securities holdings

because they are trying to earn short-term proTits, so they will hide their
holdings.
Answers to the questions:
What the cost of the securities? $6,025
What the fair value? $5,746
What is the book value? TS, AFS will show at Fair market value in
book, but HTM at cost, so total BV is $5,781
What are acc. unrealised gains and losses? Gains $49 and losses
$328.
How much have been recognized in AOCI? AFS $279 - $39 = $240
loss
How much has been recognised in NI? TS: $4 loss
What are the gains and losses on securities sold? Lets continue to another
part of the footnote:

The net loss was $24 - $56, so a $32 loss.

What was the book value of securities sold?
Dr. Cash (+A)


Dr. Loss on sale (+E)


Dr. AOCI (-E)



Cr. Marketable securities (-A)

Page 83

$9,100
$32
$18

$9,150

Are there any ways to increase 2012 pre-tax income?

AFS: Sell securities with unrealised gains. +$39
AFS: Dont sell securities with unrealised losses. +$56
Reclassify: TS losses transferred to AFS; AFS gains to TS; HTM
gains to TS.

Page 84

CHAPTER 9: TIME-VALUE OF MONEY

We say that money has time value because a dollar today is not the same
as the value of a dollar in the past or in the future. Minimum wage went
from 3.35 in 1984 to 7.25 today, but a dollar in 1984 is not the same as
today, and if we translate this amount of money, it is the same. We cant
make direct comparisons with amount of money in the past.
The time value of money differs because of inTlation, interest, risk, these
factors combine to determine the discount rate or the rate of return.
Whenever we will receive or pay cash in the future, we must adjust the
cash Tlows to the same value (usually todays value).
Much like you have to adjust foreign currencies to the US dollar (or liters
to galons) to make cross-country comparisons, you have to adjust future
dollars or past dollars to todays value to make across-time comparisons.
Example. Gasoline prices, who paid the highest price for gas?
May 2011, Fort Worth, Texas: $4.15 per gallon
May 2011, Saskatoon, saskatchewan, C$ 1.04 per liter
May 1980, Fort Worth, Texas: $1.53 per gallon
May 2011, Saskatoon
1 galon = 3.79 liters
C$ 1.04/liter x 3.79 = C$ 3.94/gallon
C$1 = $1.05
C$ 3.94 x 1.05 = $4.14 per gallon
May 1980, Fort Worth
Convert 1980 $ to 2011 $: $1 in 1980 = $2.72 in 2011
$1.53 x 2.72 = $4.16 per gallon in 2011 $
The price is the same when converted in equivalent
Compound interest. Invest $100 in a certiTicate of Deposit that earns 8%
interest per year. At the end of the Tirst year, you have:
Page 85

$100 + $8 interest = $108

This is the same as: $100 x (1 + 0.08) = $108

At the end of the second year, you have:

$108 x (1.08) = $116.64
Note that you dont have: $100 + ($8 x 2) = $116
But you do have the same as: $100 x (1.08)2 = $116.64
At the end of the third year
$116 x (1.08) = $125.97
$100 x (1.08)3 = $125.97

Future values

Generalizing the idea. At the end of the nth year, you have:
Future value in n years (FV) = $100 x (1.08)n
If the CD paid r% interest instead of 8% interest:
FV = $100 x (1 + r)n
If your initial investment was $PV instead of $100:
FV = PV x (1 + r)n
PV = FV / (1 + r)n
Thus, the present value (PV) of what you invest today at an interest rate r
grows by (1 + r)n to earn a Future value (FV) in n years from now.
PV = Present Value
FV = Future Value (after the effects of interest or discounting)
r = Interest rate, Discount rate, or Rate of return
n = Number of periods between PV and FV
FV = PV x (1 + r)n
FV = PV x (table 1 factor for n, r)
= - FV (r,n,0,PV) in Excel (r of 10% would be 0.10)
Page 86

If you invested $10,000 in the stock market today, how much money would
you have at retirement?
Assume the following:
20 years to retirement (n)
Expected rate of return (r) in stock market is 15%
FV= PV x (1 + r)n
FV = 10,000 x (1.15)20 = $163.665

We get to the same result using the table above (Table factor for 20, 15%).

Present values
Now, lets do the same in reverse for Present value.
FV = PV x (1 + r)n
PV = FV / (1 + r)n
Page 87

How much would you have to invest today in a CD that earns 8% interest
per year to have $108 next year?
PV = $108 / (1.08) = $100
How about if you want $125.97 in three years?
PV = $125.97 / (1.08)3 = $100
How bout if you want $100 next year?
PV = $100 / (1.08) = $92.59
The present value of $1 next year is 93 cents at 8%
The present value is almost always inferior to the future value as interests
rates are normally positive.
PV = FV / (1 + r)n
PV = FV x (Table 2 factor for n, r)
= - PV (r,n,0,FV) in Excel (r or 10 % would be 0.10)
How much should you have invested in a savings bond twenty years ago to
have $10,000 today?
Assume the following:
Savings bonds have no periodic interest payments (interest is
added to the principal and compounded)
Interest on the bond was 15% (compounded annually)
PV = 10,000 / (1 + 0.15)20
PV = $611
As with Future values, we can use a table factor to calculate, but we are not
going to show it here.
Net present value and decision-making. We will lay out a timeline of the
cash inTlows and outTlows, convert the CF in each period to present value,
then add up the present values. Net present value is the sum of Present
values, it often involves a cash outTlow in todays dollars and cash inTlows
in future dollars, which must be discounted back to present value.

Page 88

Example of two project comparison. NPV is used to compare which project

is more valuable for the company.

Cash Tlow payoff is faster for project B, but the sum of cash Tlows is lower.

To compare them, we need to convert them. At a 10% rate, we get:

We add the DCF and get the same value of $37, so both projects have the
same value at the given rate of 10%.

Annuities

Present value of an annuity. An annuity is a constant stream of future

cash Tlows; we have two categories of annuities:
Ordinary annuity (annuity in arrears): payments are at the end of
the period
Annuity due (or in advance): payments are at the start of a period.
Example. PV of an ordinary annuity of $500 for three periods at an
interest rate of 8%.
PV of $500 one year from now at 8% = 500 x 0.92593
PV of $500 one year from now at 8% = 500 x 0.85734
PV of $500 three years from now at 8% = 500 x 0.79383
PV = $500 x 2.57710 = $1,288.55
Page 89

The annuity formula only works if the annuity have constant streams of
payments. If not, we need to calculate the PV of each cash Tlow stream.
Present value calculations of annuities.
PV = PMT/r x [1 - 1/ (1 + r)n]
PV = PMT x Table 4 factor for n, r
= - PV (r,n,PMT,0) in Excel
If this course gets you an extra $5,000 per year in salary until retirement,
how much would you be willing to pay for it?
20 years to retirement
InTlation is expected to be 15%

PV = 5,000 (Table 4 factor for 20, 15%)

PV= 5,000 x 6.2593
PV = $31,297
Present value is inversely related to r and positively related to PMT and n.
Page 90

Future value of an annuity.

FV = PMT x (table 3 factor for n,r)
= - FV (r,n,PMT,0) in Excel
If this course gets you an extra $5,000 per year in salary until retirement,
how much is this worth when you retire?
20 years to retirement
InTlation is expected to be 15%

FV = 5,000x (Table 3 factor for 20, 15%)

FV = 5,000 x 102,4436
FV = $512,218
So far, we have done annual compounding, but what about semi-annual
compounding? (Bonds)
Divide the annual rate (r) by 2 and multiply (n) by 2
What is PV of $1,000, 5-year, 12% savings bond with.
Annual compounding?
Page 91

PV = 1,000 x (Table factor for 5, 12%) = $567

Semi-annual compounding?
PV = 1,000 x (Table 2 factor for 10, 6%) = $558
Monthly compounding?
PV = 1,000 x (Table 2 factor for 60, 1%) = $550
Price of a bond. How much would you pay a newly 3-year bond that pays
coupon payments of $250 every six months and $10,000 at maturity. The
current market interest rate is 5.0%.
PV calculation to get the bond price:
With semi-annual payments, double the number of periods (3 x 2 = 6) and
divide the interest rate by 2 (5% / 2 = 2.5%)
Present value of payment maturity
PV = ?, FV = 10,000, r = 0.025, n = 6, PMT = 0
PV = $8,623
Present value of semi-annual payment
PV = ?, FV = 0, r = 0.025, n = 6, PMT =25-
PV = $1,377
Price = $10,000 (8,623 + 1,377)

Page 92

CHAPTER 10: LONG-TERM DEBT AND BONDS

Current liabilities are due within less than one year, they are initially
booked at nominal value (not present value)
For long-term liabilities (due in periods beyond one year), they will be
booked at present value of future cash payments.
After initial recognition, some liabilities can be market to fair value while
most are recorded at amortised cost. As a result, liabilities can be a mix of
fair value and amortised cost.

Common types of debt:

Bank loan: the company borrows principal, make periodic interest
payments and Tinally repays the principal at the end of the loan.
Mortgage: companies borrows principal, make periodic interest
and principal payments over the loan period.
Corporate bonds: company promises to pay periodic cash Tlows
(coupons), plus a lump sum (principal) at maturity. Investors
offer the company the present value of coupons and principal and
can trade the bonds freely until maturity. Zero coupon bonds are
bonds where the company only pays a lump sum at maturity.
Loan example. On 1/1/2010, KP Inc. borrows $10,000 from a bank for a
3-year loan. The bank charges the Tirm 5.0% interest per year on the loan.

Issuance:
Dr. Cash (+A)

Cr. Notes payable (+L)
Page 93

$10,000

$10,000

Periodic interest payments:

Dr. Interest expense (+E,-SE)
Cr. Cash (-A)

Repayment:
Dr. Interest expense (+E,-SE)
Dr. Notes payable (- L)
Cr. Cash (-A)

$500

$500
$10,000

$10,500

$500

Mortgage example. On 1/1/2010, KP Inc. borrows $10,000 from a bank

on a 3-year mortgage. The bank charges KP 5.0% interest/year on the
mortgage. The required payment is $3,672 per year.

PV calculation to get payment:

PV= = 10,000, FV = 0, r = 0.05, n = 0.05, n = 3, PMT = ?
PMT = $3,672

On a timeline, we will have:

Page 94

Issuance:
Dr. Cash (+A)


Cr. Mortgage payable (+L)

$10,000

$10,000

2010 payment:
Dr. Interest expense (+E,-SE)

$500
Dr. Mortgage payable (- L)

$3,172
Cr. Cash (-A)



$3,672

Same for the following years with different amounts to account for the
decrease of principal.
Bond payable. Coupon bonds require semi-annual coupon payments plus
payment of face value at maturity.
Elements and terminology:
Price or proceeds (PV)
Face value or par value (FV)
Market interest rate or effective rate or yield-to-maturity (r)
Coupon rate (stated in bond agreement)
Coupon payment (PMT) = face value x coupon rate
Number of periods (n)
Because bonds are semi-annual, double the number of period,
divide rate by 2
Bond price
Price = Present value of FV + Present value of PMT
Accounting for a bond example. On 1/1/2010, KP Inc. issues a 3-year,
5% coupon, $10,000 face value bond. Investors price the bond using an
effective (market ) interest rate of 5.0%. KP receives proceeds from the
bond of $10,000.
PV calculation to get bond price:
Double the number of periods and divide the interest rate by 2!
Present value of face value:
o PV = ?, FV = 10,000, r = 0.025, n = 6, PMT = 0
o PV = $8,623
Page 95

Present value of payment

o PV = ?, FV = 0, r = 0.025, n = 6, PMT = 250 (10,000 x 0.025)
o PV = $1,377
Price = $10,000 (8,623 + 1,377)
Can also price everything by putting:
o PV = ?, FV = 10,000, r = 0.025, n = 6, PMT = 250
o PV = $10,000

The payment schedule looks like this:

Issuance:
Dr. Cash (+A)

Cr. Bonds payable (+L)

$10,000

$10,000

Periodic coupon:
Dr. Interest expense (+E,-SE)
Cr. Cash (-A)

$250

Maturity:
Dr. Interest expense (+E,-SE)
Dr. Bonds payable (- L)
Cr. Cash (-A)

$250
$10,000

$10,250

$250

Discount and premium bonds

The KP bond was assumed to be issued at par with coupon rate =
effective (market) rate, but companies can issue bonds with coupon
payments of any amount, regardless of the market rate.

Page 96

When the coupon rate is below the market rate, the bond is referred to as a
discount bond. Price is below fair value, investors pay less for bond
because coupon rate is less than current market rate.
When the coupon rate is above the market rate, the bond is referred to as a
premium bond. Price is above fair value, investors pay more for bond
because coupon rate is greater than current market rate.
Effective interest method. Interest expense only equals the coupon
payment for bonds issued at par. Interest expense must be based on the
effective interest rate:
Effective interest rate is the market rate in effect at the time of
issuance
The effective rate is not changed over the life of the bond, even
when market interest rates change.
Interest expense journal entry:
Dr. Interest expense (+E,-SE)
<Bonds pay Bal x Eff Int r>
Dr. or Cr. Bonds payable (- / +L)
<Plug>
Cr. Cash (-A)


<Face value x Coupon r>
If Interest expenses does not equal Cash, there will be Dr or Cr to
Bonds payable to balance the entry.
Effective interest method example. Bond issued at par, Effective rate =
5%; Coupon rate = 5%, Proceeds = $10,000, Face value = $10,000.

Dr. Interest expense (+E,-SE)

Dr. or Cr. Bonds payable (- / +L)
Cr. Cash (-A)

$250

$0
$250

Bond issued at a discount. Effective rate = 6%, Coupon rate = 5%,

Proceeds = $9,729, Face value = $10,000.

Dr. Interest expense (+E,-SE)

Cr. Bonds payable (+L)
Cr. Cash (-A)

Page 97

$292 (9,729 x .03)

$42

$250

Bond issued at a premium, effective rate = 4%, Coupon rate = 5%,

Proceeds = $10,280, Face value = $10,000.

Dr. Interest expense (+E,-SE)

Dr. Bonds payable (-L)
Cr. Cash (-A)

$206 (10,280 x .02)

$44

$250

Accounting for a discount bond. On 1/1/2010, KP issues a 3-year, 5%

coupon, $10,000 face value bond. Investors price the bond using an
effective (market) interest rate of 6.0%. KP receives proceed from the
bond of $9,729.

PV calculation to get bond price:

PV = ?, FV = 10,000, r = 0.03, n = 6, PMT = 250 (10,000 x 0.025)
Note the r = effective rate and PMT is based on coupon rate
Issuance.
Dr. Cash (+A)

Cr. Bonds payable (+L)

$9,729

$9,729

The proceeds are below of the Face value of $10,000 to be paid at maturity.
This will be adjusted by the plugs.
Here are the successive coupon payments entries. Here is the journal entry
at 6/30/2010:
Dr. Interest expense (+E,-SE)

$292 (9,729 x .03)
Cr. Bonds payable (+L)


$42
Cr. Cash (-A)



$250
Page 98

Here is the journal entry at 12/31/2012:

Dr. Interest expense (+E,-SE)

Dr. Bonds payable (-L)

Cr. Bonds payable (+L)

Cr. Cash (-A)

$299 (9,951 x .03)

$10,000

$49

$10,250

Accounting for a Discount bond and the SCF. For bonds issued at a
discount, part of the Interest expense will be non cash each period. The
non cash amount is equal to the plug in Bonds payable.

Dr. Interest expense (+E,-SE)

Cr. Bonds payable (+L)
Cr. Cash (-A)

$292 (9,729 x .03)

$42

$250

The non cash amount must be added back in the Operating section of the
SCF under the Indirect method. This line item is often called Amortization
of Bond discount.
Accounting for a Premium bond. There are very few cases of bonds
issued at a premium. On 1/1/2010, KP Inc. issues a 3-year, 5% coupon,
$10,000 face value bond. Investors price the bond using an effective
(market) interest rate of 4.0%. KP receives proceeds from the bond of
$10,280.
PV calculation to get the bond price:
PV = ?, FV = 10,000, r = 0.02, PMT = 250 (10,000 x 0.025), n = 6
PV = $ 10,280
Issuance. Journal entry:
Dr. Cash (+A)

Cr. Bonds payable (+L)

Page 99

$10,280

$10,280

The schedule would look like this:

Journal entry at 12/31/2012:

Dr. Interest expense (+E,-SE)
Dr. Bonds payable (-L)
Cr. Cash (-A)

$292 (9,729 x .03)

$44

$250

Retirement before maturity. Firms sometimes retire bonds prior to

maturity if they have excess cash or as part of reTinancing activities. The
Tirm typically must buy the bonds back from investors at current market
prices. The price the Tirm pays to buy back the bonds will typically be
different from the book value of the bonds.
A gain or loss is recorded on the Income statement for the difference
between the book value and the price of the bonds. The gain of loss is
backed out of the Operating section of the SCF under the Indirect method
because it is a Tinancing activity.
Example. On 7/1/2011, KP Inc. decides to buy its 3-year, 5% coupon,
$10,000 face value bond, which was issued at an effective interest rate of
6%. The market interest rate has dropped to 4%, so KP must pay $10,144
to retire the bond.

Page 100

Journal entry on 7/1/2011:

Dr. Bonds payable (-L)
Dr. Loss on retirement (+E)
Cr. Cash (-A)

$9,858
$286

$10,144

Gain example. Same bond but the market interest rate has climbed to 8%,
so KP must pay $9,584 to retire the bond. The balance is the same as
above.
Journal entry on 7/1/2011:
Dr. Bonds payable (-L)

Cr. Gain on retirement (+R)
Cr. Cash (-A)

$9,858

$274

$9,584

Under both US GAAP and IFRS, companies have the option to measure
long-term debt at fair (market) value rather than at amortised cost using
historical market interest rates.
Under amortised cost, the book value of long-term debt on the balance
sheet can deviate substantially from the current market value of the debt.
Under the fair value option, companies must adjust book value of long-
term debt each period to reTlect the current market value.
Increase in market value
Cr. Unrealized loss (+E)
Cr. Bonds payable (+L)

$XXX

$XXX

Decrease in market value

Cr. Bonds payable (-L)
Cr. Unrealized gain (+R)

$XXX

$XXX

Non-Tinancial Tirms do not want to use this method usually.

Page 101

Lease contract
A lease is a rental agreement where one party (the lessor) transfers to
another party (the lessee) the right to use an asset for a stated period of
time in return for a stated series of payments.
Common leased assets are airplanes, buildings, equipment and vehicles.
Leases can be of any duration:
Short-term leases: allow use of an asset that would be inefTicient to
purchase. Like the use to rental car for one week under a contract
that can be cancelled at any time
Long-term leases: similar to a Tinancing arrangement to purchase a
long-lived asset. Like the use of a car for 5 years under a non-
cancellable contract.
Capital lease vs Operating lease. Accounting rules require that certain
long-term leases be treated as if the company bought the asset with debt
Tinancing.
Capital leases:
Record a Lease asset and Lease liability on the Balance sheet
Record Depreciation expense and Interest expense on the Income
statement
But other long-term leases can still be treated as rentals. Operating leases:
Off-balance sheet activity: no asset or liability on the Balance sheet
Record Rent expense on the Income statement
Capital lease vs Operating lease. Firms must use capital lease accounting
if one of the following applies:
Ownership is transferred at end of lease
A bargain purchaseoption exists (right to buy asset at lease end
for less than market value)
Lease period covers more than 75% of assets life
Present value of contractual future lease payments is at least 90%
of the current market value of the asset

Page 102

Tax rules are different and are irrelevant for the choice of capital vs
operating lease accounting for Tinancial reporting.
Example operating lease. On January 1, 2010, Ople Inc. signs a 3-year
lease on a supercomputer, which is delivered that day. the lease requires
payments of $19,709 at the end of each year.
There is no bargain purchase option or ownership transfer
Ople management estimates that the lease term is 60% of the
assets life
Ople management compute the PV of the lease payments as
$44,264 using a 16% rate, This PV is 88.5% of the current market
value of $50,000.
Journal entry: No entry
On december 31, 2010, Ople makes its lease payment of $19,709 (then
same entry repeated).
Journal entry:
Dr. Rent expense (+E,-SE)
Cr. Cash (-A)

$19,709

$19,709

Example Capital lease. On January 1, 2010, Caple Inc signs a 3-year lease
on a supercomputer, which is delivered that day. The lease requires
payments of $19,709 at the end of each year.
There is no bargain purchase option or ownership transfer
Caple management estimates that the lease term is 60% of the
assets life
Caple management compute the PV of the lease payments as
$45,000 using a 15% rate, This PV is 90% of the current market
value of $50,000.
Journal entry:
Dr. Lease asset (+A)

Cr. Lease Liability (+L)

$45,000

$45,000

Page 103

Under capital lease treatment, Caple will do the following subsequent

accounting. Lease asset is depreciated on a straight-line basis for three
years with no salvage value, treated as a Long-lived asset.
Lease liability is accounted for using the effective interest method, which is
part of the lease payment considered Interest expense and part
considered payment of principal (i.e., re suction in Lease liability)
The interest expense will be equal to the beginning balance in
Lease liability times 15% (the effective interest rate)
Treated just like a mortgage payable
On December 31, 2010, Caple makes its lease payment of $19,709. Caple
also must recognize depreciation on the supercomputer.
Dr. Interest expense (+E,-SE)

$6,750
Dr. Liability (- L)


$12,959

Cr. Cash (-A)



$19,709

Dr. Depreciation expense (+E,-SE)

Cr. Acc Dep (+XA, -A)

$15,000

$15,000

The total expense is $21,750 (6,500 + 15,000) and the ending balance of
lease liability is $32,041 (45,000 - 12,959).
Same on 2011:
Dr. Interest expense (+E,-SE)
Dr. Liability (- L)


Cr. Cash (-A)

$4,806
$14,903

$19,709

Dr. Depreciation expense (+E,-SE)

Cr. Acc Dep (+XA, -A)

$15,000

$15,000

The total expense is $19,806 and the ending balance of Lease liability is
$17,138.
Then, on December 31, 2012, Caple makes its lease payment of $19,709.
Caple also must recognize depreciation on the supercomputer.
Dr. Interest expense (+E,-SE)

$2,571
Dr. Liability (- L)


$17,138
Page 104

Cr. Cash (-A)

Dr. Depreciation expense (+E,-SE)

Cr. Acc Dep (+XA, -A)

$19,709

$15,000

$15,000

The total expense is $17,571 and the ending balance of Lease liability is
$0.

Capital lease method has higher expenses in early years, lower in later
years. Total expenses have higher Assets and Liabilities than Operating
leases, which are off-balance sheet.
SCF and Capital vs Operating lease.

Companies using capital leases always have higher Cash Tlow from
operations.
Operating leases
Rent expense is an Operating cash Ilow
Capital leases
Page 105

Interest expense is an Operating cash Ilow

Reduction in the lease liabilities is a Financing cash Ilow
Depreciation expense is a non-cash expense

This accounting for leases is controversial because operating lease

accounting allows Tirms to keep substantial obligations off their balance
sheet, potentially distorting the Tirms leverage.
The FASB and IASB are both currently considering proposals to eliminate
operating lease accounting.
Converting Operating leases to Capital leases.
Adjust Balance sheet
o Calculate the PV of minimum future operating lease
payments disclosed in footnotes
o Capitalize these leases by adding the PV Long-term Assets
and to Long-term debt. Or as a quick shortcut, multiply
rent expense by 8 to estimate the asset/liability.

Page 106

C HAPTER 11: T AXES AND THE FINANCIAL

STATEMENTS
There are two certainties in life, death and taxes, we will look in this
chapter to the latter, the former beyond the scope of this course.
Tax reporting vs 9inancial reporting.

Taxable income is different from Pre-tax income. The two amounts can be
different. Examples:

Page 107

Tax accounting is all about raising taxes while Tinancial accounting is about
providing a clear picture of the company.
Example. EBITDA in this example is Earnings before depreciation,
municipal bond interest revenue, and taxes.
Permanent differences. Revenues that are never included in taxable
income and expenses that are never deductible for tax purposes.
Example,:Interest on tax-exempt municipal bonds, tax penalties and tax
credits, state and foreign taxes.

These permanent differences do not reverse over time and cause the
Effective tax rate to not equal the Statutory tax rate.
Temporary differences. Revenues or expenses recognised in a different
period for tax purposes than for Tinancial reporting purposes. Examples:
book vs tax depreciation, bad debt expense, unearned revenue

These differences will reverse over time, and will be stored in Deferred tax
assets and liabilities.
Pretax Income vs Taxable income. Pretax income is Earnings before
taxes under GAAP vs Taxable income which is Earnings before taxes under
tax rules. So, differences between pre-tax income and taxable income arise
from permanent and temporary differences.

Page 108

Statutory rate is the Tax rate set by the government.

Income tax payable are the Taxes owed to the government.
Taxable income x statutory rate

Adjusted pretax income is used to compute Income tax expense for

Tinancial reporting purposes. It is Pretax income adjusted for permanent
differences.

Page 109

Income tax expense is the number reported on the Income statement,

Adjusted pretax income tomes the Statutory rate, differs from Income tax
payable due to temporary differences.
Temporary differences reverse over time!

Effective tax rate. Effective tax rate = Income tax expense / Pretax
Income, it does not equal 35% (the statutory rate) because of permanent
differences and do not reverse.

Page 110

Deferred tax liabilities

We will now be looking at what these differences create in the balance
sheet, here, the Deferred tax liabilities.
Temporary differences are differences between Income tax expense on the
Tinancial statements and Income tax payable to the government that will
reverse over time.

Income tax expense = Adj. pretax income x statutory tax rate

Adjusted pretax income based on GAAP rules and excludes permanent
differences. For convenience, I will say Pretax income instead of
Adjusted pretax income.

Income tax payable = Taxable income x statutory tax rate

Taxable income based on tax code rules, it will be paid the government.
Temporary differences are stored in Deferred tax assets and Liabilities. We
will use 35% as the statutory rate in the US.
Deferred tax liabilities arise from temporary differences where, initially, tax
rules require bigger expenses or smaller revenues than GAAP
Pretax income > Taxable income
Income tax expense > Income tax payable
The Deferred tax liability represents the obligation to make higher tax
payments. Journal entry today:
Dr. Income tax expense (+E,-SE) $100
Cr. Deferred tax liability (+L)
$10
Cr. Income tax payable (+L)
$90
In the future, GAAP will require bigger expenses or smaller revenues than
tax rules
Pretax income < Taxable income
Income tax expense < Income tax payable
Page 111

The future journal entry will look like this:

Dr. Income tax expense (+E,-SE) $90

Dr. Deferred tax liability (-L)
$10
Cr. Income tax payable (+L)

$100

Example. Brey Co. buys a $120,000 machine on 1/1/2010. For book

purposes, it estimates that the machine will have a 3-year life with no
salvage value. For tax purposes, the MACRS schedule dictates a
depreciation schedule of $80,000, $27,000 and $13,000 in the three years.

2010 journal entry:

Dr. Income tax expense (+E,-SE) $21,000
Cr. Deferred tax liability (+L)
$14,000
Cr. Income tax payable (+L)
$7,000

2011 journal entry:

Dr. Income tax expense (+E,-SE) $21,000
Dr. Deferred tax liability (-L)
$4,550
Cr. Income tax payable (+L)
$25,550

Page 112

2012 journal entry:

Dr. Income tax expense (+E,-SE) $21,000
Dr. Deferred tax liability (-L)
$9,450
Cr. Income tax payable (+L)
$30,450
We dont use PV for tax issues. We might account for tax rate changes.

Temporary difference: timing of depreciation expense and tax expense is

shifted across time, but totals are the same between books and taxes.
This system is good for companies because the tax liability gives you a tax
break at the beginning, and a dollar not spent today is worth more than a
dollar not spent in the future!

Deferred tax assets

They arise from temporary differences where initially, tax rules require
smaller expenses or bigger revenues than GAAP.
Pretax income < Taxable income
Income tax expense < Income tax payable
The deferred tax asset represents the beneTit of tax savings in the future
Page 113

Today journal entry:

Dr. Income tax expense (+E,-SE) $90
Dr. Deferred tax asset (+A)
$10
Cr. Income tax payable (+L)

$100

In the future, GAAP will require smaller expenses of bigger revenues than
tax rules.
Pretax income > Taxable income
Income tax expense > Income tax payable
Future journal entry:
Dr. Income tax expense (+E,-SE) $100
Cr. Deferred tax asset (-A)
Cr. Income tax payable (+L)

$10
$90

Example. Brey Co. recognises $80,000 of Bad debt expense on 2010 sales.
There are write-offs of those sales in 2010. In 2011, Brey wrote-off
$30,000 of accounts. In 2012, Brey wrote off $50,000 of accounts.
EBTBD = Earnings Before Taxes and Before Bad Debt. In 2010:

2010 Journal entry:

Dr. Income tax expense (+E,-SE) $7,000
Dr. Deferred tax asset (+A)

$28,000
Cr. Income tax payable (+L)
$35,000
For the sake of clarity, we will assume that there is no additional bad
expense allowance in 2011, but in reality, there is always some. In the tax
system, we will recognise the expense when they really happen, not when
the sale is recorded, so 30,000 in 2011.
Page 114

2011 Journal entry:

Dr. Income tax expense (+E,-SE) $35,000
Cr. Deferred tax asset (-A)
$10,500
Cr. Income tax payable (+L)
$24,500

2012 Journal entry:

Dr. Income tax expense (+E,-SE) $35,000
Cr. Deferred tax asset (-A)
$17,500
Cr. Income tax payable (+L)
$17,500

This is a temporary difference, timing of bad debt expense and tax expense
is shifted across time, but totals are the same between books and taxes.

Page 115

Changes in Future tax rates

Deferred tax assets and liabilities must be based on expect future tax rates.
Generally, assume that current tax rate will continue into future.
If the government changes the statutory tax rate, the balances in DTA and
DTL must be adjusted to reTlect the new rate, with the adjustment running
through Income tax expense.
Tax rate increase:
DTAs increase => Dr. Deferred tax asset (+A), Cr. Inc tax expense (-E)
DTLs increase => Dr. Income tax expense (+E), Cr. Def. tax liab. (+L)
Tax rate decrease:
DTAs decrease => Dr. Inc. tax expense (+E), Cr. Deferred tax asset (-A)
DTLs decrease => Dr. Def. tax liab. (-L), Cr. Inc. tax expense (-E)
Example with DTL. At the end of 2011, the government increases the tax
rate to 40%. Balance in DTL account in Brey account is $9,450, under 35%
tax rate.

Pretax difference = $9,450 / 0.35 = $27,000. Note: this is the difference in

Acc. Dep. (107,000 - 80,000).
DTL at new rate = $27,000 x 0.40 = $10,800
Required increase in DTL = 10,800 - $1,350

Dr. Income tax expense (+E,-SE) $1,350

Cr. Deferred tax liab (+L)
$1,350

Page 116

Example with DTA.

Balance in DTA is $17,500 (under 35%), pretax difference = $17,500 / 0.35

= $50,000.
DTA at new rate = $20,000 x 0.40 = $20,000
Required increase in DTL = 20,000- $17,500 = $2,500

Dr. Deferred tax asset (+A)

$2,500
Cr. Income tax expense (-E)
$2,500

This is a negative expense, yes, this is possible

Valuation allowances and NOLs

We will now see how losses can shield you from paying taxes. Sometimes,
we have to create a valuation allowance for Deferred tax assets; they
represent future tax savings, i.e. a reduction in future cash outTlows.
But companies can only realise tax savings if they are proTitable. DTA
reduces taxes paid, but will not produce a refund if the company does not
have to pay taxes, and companies do not have to pay taxes when they have
negative taxable income.
So, to use a DTA, a company must have a positive taxable income and a
positive income tax payable.

Page 117

Companies can only report a Deferred tax asset if is more likely than
not (75% chances) the Tirm will be proTitable enough in the future to take
advantage of tax savings.
If it is not more likely than not, companies must reduce the DTA using a
Valuation allowance (XA), works like Allowance for doubtful accounts.
Net Operating Losses (NOLs). A net operating loss occurs in a year when
taxable income is negative, federal tax law permits taxpayers to use an
NOL to offset the proTits and future years.
First, carry the NOL back 2 years and receive refunds for income taxes that
have already been paid in those years. Again, if we consider time value of
money, this make sense as it is better to save money earlier than later.
Any loss remaining after the 2-year carry back can be carried forward up
to 20 years to offset future taxable income. After 20 years, it disappears.
Create a Deferred tax asset for the amount of tax savings due to NOL carry
forwards.
Example: NOLs. In 2011, Noll International Inc. experienced an $80,000
net operating loss (i.e. negative taxable income) in its US subsidiary, and a
$150,000 net operating loss in its Liechtenstein subsidiary.
Noll did not pay taxes in 2009 - 2010 in either jurisdiction, so it cannot
carry the loss back to get a refund.
Noll expects it is "more likely than not to be able to use NOL carry
forwards in 2014 in both countries. US tax rate is expected to be 35%. The
US DTA is $80,000 x .35 = $28,000. Liechtenstein tax rate is expected to be
15%. The Li DTA is $150,000 x .15 = $22,500.
Journal entry:
Dr. Deferred tax asset (+A)
$50,500
Cr. Income tax expense (-E)
$50,500

Page 118

In June 2012, Noll is preparing its quarterly reports and has serious
doubts about the future proTitability of its Liechtenstein subsidiary. Noll
decides that it is not more likely than notto be able to use NOL carry
forwards in Liechtenstein before it expires. (Li DTA is $150,000 x .15 =
$22,500)
Journal entry:
Dr. Income tax expense (+E)
$22,500
Cr. Valuation allowance (+XA)
$22,500
Disclosure presentation: Deferred tax assets

DTA: NOL Carryforwards
50,500

Less Valuation allowance
(22,500)

Net Deferred tax assets
28,000
In Dec. 2012, Noll is preparing its annual report and is now very optimistic
about the future proTitability of its Liechtenstein subsidiary. Noll decides
that it is "more likely than not" to be able to use NOL carry forwards in
Liechtenstein by 2014.
Journal entry
Dr. Valuation allowance (-XA)
$22,500
Cr. Income tax expense (-E)
$22,500
Be careful about this artiTicial way of creating a negative expense, and
some additional income.

Chapter disclosure example

Elements:
Components of Income before tax: Domestic vs foreign
Components of Income tax expense: Currently payable vs deferred
Reconciliation form Statutory to Effective tax rates: Permanent
differences
Components of Deferred tax assets and liabilities: temporary
differences and Valuation allowance
Page 119

 Differences between Footnote and Balance sheet:

Deferred tax assets and liabilities may be netted by jurisdiction
(any entity that can tax you, countries, cities, etc) on the Balance
sheet
Deferred tax assets and liabilities may be split into current and
non current portions
Moth Inc. manufactures construction equipment. Questions to answer
from Moths Income tax footnote:
What is the effect of Moths non-US subsidiaries on its 2012 effective
tax rate?
Provide a summary journal entry for 2012 Income tax expense
Provide the journal entry for the change in Valuation allowance
during 2011. Why did Moth make this entry? What effect does this
entry have on net income?
Was Moth Warranty expenses for tax purposes higher or lower than
its Warranty expense for book purposes in 2012?
Was Moths depreciation expense for tax purposes higher or lower
than its depreciation expense for book purposes in 2012?
Here is footnote 6 from Moth:

Page 120

Effect of non-US subsidiaries on 2012 ETR (Effective Tax Rate)? Non-US

subsidiaries increased ETR by 1.9%. It represents extra tax on the same
pretax income => Permanent difference. For tax calculations, we will use
statutory rate: 35%.
Journal entry for 2012 Income tax expense? Lets look at the rest of the
footnote:

Page 121

Journal entry:
Dr. Income tax expense (+E)
$455
Cr. Deferred taxes (+?)

Cr. Income tax payable (+L)

$65
$390

More details? Cf footnote below

Deferred tax assets: Debit of 120 (1916 - 1796)
Deferred tax liabilities: Credit of 175 (521 - 346)
Valuation allowance: Credit of 11 (72 - 61)
Cr. Deferred taxes 65:
Dr. Deferred tax asset (+A)
$120
Cr. Deferred tax Liab (+L)
Cr. Valuation allowance (+XA)

$175
$10 (rounding pb)

Journal entry with more details:

Dr. Income tax expense (+E)
Dr. Def. tax assets (+A)
Cr. Def. tax liab. (+L)
Cr. Valuation allow. (+L)

$175
$10

$455
$120

Page 122

Cr. Income tax payable (+L)

$? details?

We need more details on Income tax payable, in the note, we have: We

paid income taxes of $306, $714, and $709 in 2012, 2011, and 2010,
respectively.

Cash paid for income taxes, $306 in 2012, so Cr. Income tax payable =
Cr. Cash (-A)


$306
Cr. Inc. tax payable (+L)

$84
If we put it back in the large journal entry, we get:
Dr. Income tax expense (+E)
$455
Dr. Def. tax assets (+A)
$120
Cr. Def. tax liab. (+L)

$175
Cr. Valuation allow. (+L)

$10
Cr. Income tax payable (+L)
$84
Cr. Cash (-A)


$306
Journal entry for 2011 change in Valuation allowance. Decrease of $68 (61
- 129) => Dr. Valuation allow. (-XA)
$68

Cr. Inc. tax exp (-E)

$68

Page 123

This entry resulted in an Increase Net income by $68. Why did the
Valuation allowance decrease in 2011?

Circumstances changed at certain of our European subsidiaries. The

question remaining is what changed?. More details would be interesting.
DTA: Warranty reserves. There is a Deferred tax asset created because
warranties are expensed in Tinancial accounting when the product is sold,
but only when cash is expensed for tax purposes. (see Tigure below)
Warranty DTA increased $43 (237 - 194)
Dr. Income tax expense (+E)
Dr. Def. tax assets (+A)
$43
Cr. Def. tax liab. (+L)

Income tax expense < Income tax payable for warranty by $43. So, Pretax
income < Taxable income by $123 (43/.35)
Book warranty expense > Tax warranty expense by $123
So Moth must be growing sales, or pay less warranty than expected.
DTL: Deferred tax liability. Lets do the same exercise for a Deferred tax
liability, and check the difference in Depreciation expense. Capital assets
DTL increased by $120 (383 - 263).
Dr. Income tax expense (+E)
Cr. Def. tax liability (+L)

$120
Page 124

Cr. Def. tax liab. (+L)

Income tax expense > Income tax payable for depreciation, by a $120.
Pretax income > Taxable income by $343 (120/.35)
Book depreciation expense < Tax depreciation expense by $343.
It means that Moth must be growing its Capital assets and is investing.


Taxes, SCF and Marketable securities
We ignored taxes in previous topics, as all operating activities line items
on the SF are shown pretax: Depreciation, Inventory, Accounts payable,
etc.
we will take a look at a Cash Tlow statement from a previous video. all
effects in taxes will be reTlected in:
Changes in Deferred taxes
Changes in Income tax payable
Example. A company decides to increase its book Depreciation by $100 in
2011. Pretax income down by $100
Income tax expense down by $35 (100 x .35)
Net income down by $65 (100 - 35)
Tax depreciation is unaffected, Taxable income is unaffected, Income tax
payable does not change.
We need to balance these differences with a reduction in Deferred tax
liability.
Dr. Depreciation expense (+E)
$100
Cr. Acc Depreciation (+XA)
$100
Dr. Def. tax liab. (-L)

$35
Cr. Income tax expense (-E)
$35
Now, lets take a look at the impact on the Cash Tlow statement. After we
make these changes:

Page 125

1/ If we change non cash expense, there can not be any change in

the Operating cash Tlows
2/ We were able to do add back on a pretax basis, because we took
into account the change in Deferred taxes.
Marketable securities. Gains or losses on Marketable securities are taxed
only when sold. Tax is based on the difference between the sales price and
the purchase price.
In the Trading securities system, when Unrealized gains/losses from mark-
to-market are carried on the Income Statement, they create a Deferred Tax
asset or liability.
For Available for sale securities, Unrealized gains/losses for AFS securities
are stored in AOCI. AOCI must be carried on an after-tax basis, so we will
have to create a DTA or a DTL to reTlect the tax effect of the Unrealized
gains/losses in AOCI.
Example Trading. At quarter end, Boot Banks investment in TK stock is
now worth $129 (Bott bought the stock for $100). Journal entries:
Dr. Marketable securities (+A)
$29
Cr. Gain on investments (+R)
$29
Dr. Income tax expense
$10 (29 x .35)
Cr. Deferred tax liability (+L)
$10
Note: No income tax payable is recognised because taxes are only paid
when the security is sold.
After quarter end, Bott Bank sells its TK stock for $109. Journal entry
Dr. Cash (+A)

$109
Dr. Loss on investments (+E)
$20
Cr. Mark. securities (-A)

$129
Dr. Deferred tax liability (-L)
$10
Cr. Income tax expense (-E)
$7 (20 x 0.35)
Cr. Tax payable (+L)

$3 (9 x 0.35)

Page 126

Note: Income tax payable is based on the Realized gain computed using the
original cost (109 -100).
Available for sales securities. At quarter end, Meyer Co.s investment in
TK is now worth $129 (Meyer bought the stock for $100). Journal entry:
Dr. Marketable securities (+A)
$29
Cr. AOCI (+ SE)


$29
Dr. AOCI (- SE)

$10 (29 x .35)
Cr. Deferred tax liability (+L)
$10
Note: Instead of debiting Income tax expense, as we would if this went on
the Income statement, we debit AOCI. So the balance of the operation is 19
for AOCI.
After quarter end, Meyer Co. sells its TK stock for $109. Journal entry:
Dr. Cash (+A)

$109
Dr. AOCI (- SE)

$29
Cr. Mark. securities (-A)

$129
Cr. Gain on investment (+ R)
$9
Dr. Income tax exp. (+ E)
$3
Cr. Income tax pay. (+ L)

$3
Dr. Deferred tax liability (-L)
$10
Cr. AOCI (+ SE)


$10

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CHAPTER 9: SHAREHOLDERS EQUITY

Share issuance and share repurchases
Shareholders equity is the residual claim on assets after settling claims of
creditors (i.e. assets - liabilities)
Shareholdersequity due to share issuance:
Contributed Capital:
Common stock
Preferred stock
Treasury stock
Repurchased shares that may be issued again
Shareholders equity due to operations:
Retained earnings: End ret. earnings = Beg. Ret. Ear. + Net Inc. - Div.
Accumulated other comprehensive income: items that bypass the
Income statement
Types of stock a company can issue. First, we have Preferred stock, they
are between debt holders and common stock holders in claim on assets.
They do not have voting rights, but pay a Tixed dividend that must be paid
before common dividends. It might be callable, convertible, or redeemable.
It is way to get in equity without taking the full risk.
Then we have Common stock, which do have voting rights, but a residual
claimant to assets.
Par value is the stated value on shares used to compute balance in
Common stock or Preferred stock. Additional Paid In Capital (APIC) is the
amount received in excess of par value.
Contributed capital terminology.
Shares authorised is the total number of shares the Tirm could issue.
Shares issued: number of shares that have been sold to the public,
balance in Common stock at par based on this amount.
Shares outstanding: number of shares currently held by the public,
shares issued minus treasury shares. Dividends and Earnings per
share are based on this amount.

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Example: Issuing stock - preferred. On 1/14/2012, Stack Inc. issued

10,000 shares of no-par preferred stock for proceeds of $7 per share. The
preferred stock speciTies cumulative $1 annual dividends per share.
Journal entry:
Dr. Cash (+A)

Cr. Preferred stock (+ SE)

$70,000

$70,000

Cumulative dividends. Before paying any dividend to common stock, it

must pay any dividend that has not been paid to Preferred stock holder. If
BOC Inc. does not pay its dividend of $1 in 2010 and 2010, it must pay $2
of dividends to preferred in 2014 before paying anything to the Common
stock.
Example: Issuing stock - common. On 1/14/2012, Stack Inc. issued
12,000 shares of $1 par value stock for proceeds of $10 per share. Shares
issued and outstanding: 12,000.
Journal entry:
Dr. Cash (+A)

$120,000
Cr. Common stock (+ SE)


Cr. Add. paid in cap. (+ SE)

$12,000
$108,000

Share repurchases and Treasury stock. Companies sometimes

repurchase their own shares.
Repurchased shares are carried in the Treasury stock (XSE) account
Treasury stock does not have voting rights or dividend rights
Treasury stock can be reissued by the Tirm. Reissued stock is
removed from the Treasury stock account at the original price paid
to repurchase. APIC or Retained earnings are used to balance the
journal entry if reissue price differs from repurchase price. Because,
companies cannot book gains or losses in trading their own stock!
There are four big reasons why a company might want to repurchase some
share:
It has excess cash, instead in paying dividends, they purchase shares
to avoid some problems of dividends
The company is undervalued
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 To put the buyback shares to stock plans

To increase the leverage
Treasury stock purchase. On 3/3/2012, Stack Inc. repurchased 4,000
shares of its common stock at a price of $11 per share.
Journal entry:
Dr. Treasury stock (+ XSE)
Cr. Cash (-A)

$44,000

$44,000

Shares issued is now 12,000 and shares outstanding 8,000.

Treasury stock sales - price increase. On 4/4/2012, Stack Inc. sold
1,000 shares of its treasury stock at a price of $14 per share.
Journal entry:
Dr. Cash (+ A)

$14,000
Cr. Treasury stock (- XSE)
$11,000
Cr. Add. Paid in capital (+SE)
$3,000
Shares issued is 12,000 and shares outstanding is 9,000.
Treasury stock sale - price decrease. On 5/5/2012, Stack Inc. sold
1,000 shares of its treasury stock at a price of $9 per share.
Journal entry:
Dr. Cash (+ A)

Dr. Add. Paid in capital (- SE)
Cr. Treasury stock (- XSE)

$9,000
$2,000

$11,000

Shares issued is 12,000 and shares outstanding is 10,000. Note: if APIC has
a zero balance, debit Retained earnings.
Treasury stock retirement. We are going to take out the shares. On
5/15/2012, Stack Inc. decided to retire 1,000 shares of its treasury stock.

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Journal entry:
Dr. Common stock (- SE)
Dr. Add. Paid in capital (- SE)
Cr. Treasury stock (- XSE)

$1,000
$10,000

$11,000

Shares issued are 11,000 and shares outstanding are 10,000.

Dividends, splits and AOCI

Retained earnings is the cumulative income that has not been paid out as
dividends:
Net income: positive net income increases retained earnings;
negative net income decreases retained earnings
Dividends decreases Retained earnings since this is a return of
equity to shareholders
Cash dividends:
Declaration date. Company declares a dividend will be paid to all
investors that hold shares as of the date of record, e.g., 10 days
after the declaration date.
Date of record: date on which investors must hold shares to be
entitled to receive the dividend.
Payment date is the date on which the Tirm pays the dividend
Note: Tirms are not required to pay dividends. However, once a Tirm has
declared a dividend, the Tirm is legally obligated to pay it to its
shareholders as of the record date. That is why we create a liability called
Dividend payable on the declaration date.
Ex-dividend date, it takes 3 days after a stock transaction before it is
recorded on the ledger.
Example. On 6/6/2012, Stack Inc. declares a $0.50 dividend per share to
both common and preferred shareholders of record on 6/16/2012. The
dividend will be paid on 6/26/2012.

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Preferred shares issued and outstanding: 10,000

Common shares issued: 11,000; Common shares outstanding: 10,000
Journal entry:
Dr. Retained earnings (- SE)
Cr. Dividend payable(+ L)

$10,000

$10,000

Journal entry on 6/16/2012: No entry on date of record.

Journal entry on :
Dr. Dividend payable (- L)
Cr. Cash (- A)

$10,000

$10,000

Stock dividends and splits. Stock dividend:

Each common shareholder is given a dividend in the form of new
common shares
Each stock holders percentage ownership of the company will be
identical to what it was before the stock dividend
No cash Tlow involved
If dividend is less than 25%, reduce Retained earnings and
increase common stock and APIC using current market price of
the shares
If dividend greater than 25%, reduce Retained earnings and
increase Common stock using the par value of the shares.
Stock split:
Each common share is replaced with a given number of new
common shares
No balance sheet, income statement, or cash Tlow effect
Adjust number of shares authorised, issued, and outstanding, as
well as the par value.
Example: stock dividends. On 7/7/2012, Stack Inc. declared a 10%
common stock dividend; i.e., every shareholder received new shares equal
to 10% of current shares held. The price of Stack stock on 7/7/2012 was
$11 per share. Shares issued: 11,000; shares outstanding: 10,000.
Dividend will be 1,000 shares.

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Journal entry.
Dr. Retained earnings (- SE)
$11,000
Cr. Common stock (+ SE)
$1,000
Cr. Add. paid in capital (+ SE)
$10,000
Shares issued 12,000 and shares outstanding 11,000.
Example: stock split. On 8/8/2012, Stack Inc. announces a 2-for-1
common stock split. 12,000 shares issued and 11,000 outstanding.
No journal entry. Shares issued will be 24,000 and shares outstanding is
now 22,000. Par value is 0,50$. You can also have some reverse split.
Accumulated other comprehensive income. These are debits (expenses,
losses) and credits (revenues, gains) that bypass"the income statement
and go directly into Shareholders Equity. Rationale: companies do not like
volatile earnings caused by market movements, as unrealised gains and
losses would cause volatility in Net income. Some accounting methods
require marking assets/liabilities to fair value.
Compromise: GAAP and IFRS require companies to mark-to-market, but
allow unrealised gains/losses to bypass the Income statement, but, the
Balance sheet must balance, so unrealised gains/losses go into
Accumulated other comprehensive income, instead of through Net income
into Retained earnings.
Items go into AOCI on an after-tax basis, and the resulting tax effect of item
goes into a Deferred tax account.
AOCI items:
Unrealized gains and losses on Marketable securities
Foreign currency translation adjustments: converting the assets and
liabilities of foreign subsidiaries from the foreign currency to the
domestic currency under the current method leads to unrealised
gains and losses that go to AOCI.
Pensions: the difference between the actual gains/losses on pension
assets and the expected gains/losses on those assets goes to AOCI
Derivatives: for cash Tlow hedges.
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Statement of shareholders' equity and stock compensation

This statement reports the changes in all of the shareholders equity
accounts and presents beginning and ending balances in each account and
shows all increases and decreases during the year:
Common stock, APIC, treasury stock
Retained earnings
Accumulated other comprehensive income
Non-controlling interests.
Stock-based compensation:
Restricted stock plans: companies pay employees with shares of
stock as compensation
Stock option plans: companies grant employees the right to purchase
a number of shares at a Tixed price (called the exercise or strike
price) over a speciTied period of time (often 10 years) as
compensation. Most of the time, the exercise price is set equal to the
stock price at the time the options are granted.
Generally some vesting period (normally 1-3 years) must pass before the
employee is allowed to sell the stock or exercise the option. The value of
the restricted stock or options granted is treated as an expense and
recognised over the vesting period.
Example: restricted stock grant. On 1/1/2013, Stack Inc. grants 1,000
shares of stock to its CEO as compensation. The stock price is $20 per
share on the grant date. The stock vests two years. The par value is $0.50.
Journal entry.
Dr. Def. comp. exp. (+ XSE)
$20,000
Cr. Common stock (+ SE)
$500
Cr. Add. paid-in cap. (+ SE)
$19,500
Journal entry on 12/31/2013
Dr. comp. exp. (+ E)

Cr. Def. comp. exp.(+ SE)

$10,000

$10,000

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Journal entry on 12/31/2014

Dr. comp. exp. (+ E)

Cr. Def. comp. exp.(+ SE)

$10,000

$10,000

We assumed straight-line depreciation but there are other ways to

depreciate the expense.
Example: stock option grant. On 1/1/2013, Stack Inc. grants 100 options
to its CFO with an exercise price of $20 as compensation. The options vest
after two years and expire after 10 years. the stock price is $20 on the
grant date. The fair value of the option is $18 per share at the grant date.
The fair value of stock option grant is $1,800 (100 x $18). This will be
amortised over the vesting period.
Journal entry on 12/31/2013
Dr. comp. exp. (+ E)

$900
Cr. Add paid-in Capital (+ SE)

$900

Journal entry on 12/31/2014

Dr. comp. exp. (+ E)

$900
Cr. Add paid-in Capital.(+ SE)

$900

Example: stock option exercise. On 6/6/2018, the CFO exercises the 100
options to buy the stock at the $20 exercise price. The market price of
Stacks stock is $30 on that day. Stack re-issues treasury stock to provide
the shares. Treasury stock was acquired at $11 per share.
Journal entry
Dr. Cash (+ A)

$2,000
Cr. Treasury stock.(- XSE)
$1,100
Cr. Add paid-in Capital.(+ SE)
$900 (plug)
Note: the market price is not relevant for this journal entry, but Stack will
get a tax deduction equal to ($30 - $20) x 100 shares = $1,000. These tax
savings are considered a Cash Tlow from Tinancing; this amount is taxable
income for the CFO, so deductible for the company.

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Earnings per share

Earnings per share (EPS)- Basic. EPS provides a measure of how much
earnings was generated for each share of common stock held by outsiders
Reported by the company at earnings announcement
Forecasted by security analysts
Compared to price per share to get Price-Earnings (P/E) ratio.
Basic EPS = (Net Inc. - Pref. dividends) / Weighted average number of
common shares outstanding
Example: basic EPS. For the year ended 12/31/2013, Stack reported Net
income of $25,000. On 1/1/2013, Stack had 22,000 common shares
outstanding and 10,000 preferred shares outstanding. Stack issued 4,000
common shares on 6/30/2013. Stack paid $5,000 of preferred dividends
and $9,000 of common dividends during 2013.
Basic EPS = (25,000 - 5,000) / (22,000 + (4,000/2)) = $0.83
Earnings per share (EPS) diluted. Companies with complex"capital
structures also report Diluted EPS. Complex capital structures includes
securities that can be converted into stock at the investors discretion like
convertible debt, stock options and warrants.
Some of the value of these convertible securities is tied to the value of
common stock; thus, investors holding these securities are indirect" stock
holders.
Diluted EPS provides EPS assuming everything that could convert to a
share of stock actually did so.
Diluted EPS = (NI - Pref. div. + Adjustments) / Wtd avg shares +
adjustments
Effect of convertible debt. Convertible debt can be exchanged for common
stock, diluted EPS is computed under the assumption that the convertible

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debt had been exchanged for common stock at the start of the period; this
is called the if converted method.
In the numerator of EPS, Net income is increased by the after-tax interest
expense on the convertible bond. If debt had converted, there would have
been no Interest expense, so it is added back to Net income.
Denominator of EPS: number of shares is increased as if the debt was
converted to common shares at the beginning of the period.
Example: diluted EPS with Convertible debt. For Tiscal year 2013,
Stacks Net income of $25,000 included $500 of Interest expense on
Convertible debt. The debt is convertible into 2000 shares of common
stock. The statutory tax rate is 35%.
Basic EPS = 20,000 / 24,000 = $0.83
Diluted EPS = [20,000 + (500 x (1-.35))] / [24,000 + 2,000] = $0.78
Diluted EPS with Stock options. In the money stock options give the
holder the right to acquire a share of common stock at a pre-speciTied
price. Dilute d EPS is computed under the assumption that a fraction of the
options had converted to common shares.
This is called the treasury stock method.
In the numerator of EPS, there will be no adjustment, as it has no impact
on the Net income. In the denominator, the number of shares is increased
by a fraction of each outstanding option.
Number of additional shares = Number of options x Conversion fraction
Conversion fraction = (Avg. Stock price - Exercise price) / Avg. Stock price
Example: Diluted EPS with stock options. During Tiscal year 2013, Stack
had 1,000 outstanding in-the-money options with an average exercise
price of $10. The average stock price during the year was $20.

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Conversion fraction = (20 - 10) = 0.5

Diluted EPS (Conv. debt only) = 20,325/26,000 = $0.78
Diluted EPS = 20,325 / (26,000 + (1,000 x 0.5)) = 20,325 / 26,500 = $0.77
Diluted EPS: complications. Diluted EPS must always be less than or
equal to basic EPS. Diluted EPS is set equal to basic EPS in years when a
Tirm has a loss from continuing operations from stockholders. If diluted
EPS would be greater then Basic EPS after a convertible is added to the
calculation, the convertible is considered antidilutive"and is excluded
from computation of Diluted EPS.
Options are considered antidilutive" when the exercise price is greater
than the market price (out-of-the-money)
Disclosure example. PupCo manufactures health drinks for dogs and cats.
Questions to answer from PupCos shareholders Equity disclosure:
What are shares issued, shares outstanding, and par value for
common stock?
How much cash did PupCo get from issuing new shares in 2012?
How much cash dividends were declared and paid in 2012?
How much did PupCo pay to repurchase shares in 2012? What was
the average price?
What is the average price paid to acquire all treasury shares held at
12/31/2012?

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Shares issued: 1,865, less treasury 284; Outstanding is 1,581 shares. Par
value is 1 2/3 cents.

Common stock issued is $1, so we now have $4,547 worth of shares. It was
a non cash issuance due to acquisition.
Stock options. We will try to answer the following questions:
What are the terms of PupCo stock options?
What was the total fair value of stock options granted in 2012?
How much cash was stock-based compensation expense in 2012?
How much cash did PupCo received from options exercised in 2012?
What was the source of the stock sold to employees exercising
options?

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