Final Review part 1
Investing Activities Cash Outflows
Acquisition of businesses Purchase of PP&E Purchase of intangibles Purchase of inves
Adjusting Entries (cont)
Adjusting entries fall into one of four categories 1) Deferred Revenues 2) Deferred Expenses 3) Accrued Revenues 4) Accrued Expenses
Three fundamental equations of bookkeeping
1) 𝐴𝑠𝑠𝑒𝑡𝑠=𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠+𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟^′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 2) 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒+𝑆𝑢𝑚 𝑜𝑓 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 −𝑆𝑢𝑚 𝑜𝑓 𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠=𝐸𝑛𝑑𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 3) 𝑆𝑢𝑚 𝑜𝑓 𝐷𝑒𝑏𝑖𝑡𝑠=𝑆𝑢𝑚 𝑜𝑓 𝐶𝑟𝑒𝑑𝑖𝑡𝑠
Preparing the Financial Statements
1) Prepare the Statement of Income 2) Use Net Income to update Retained Earnings and prepare the Balance sheet. 3)-4) Finally, complete the Statement of Cash Flows and Statement of Stockholders' Equity (after midterm exam 1).
Indirect Method Preparation
1) Begin with Net Income after preparing the income statement (and presumably also the balance sheet). 2) Alter components of NI tied to noncash items or to investing activities by adjusting to add back recently matched (but not paid in current period) expenses or subtract recently recognize (but uncollected) revenues for depreciation and amortization (noncash items) for gains and losses on sale of PP&E or investments (investing activities) 3) Alter components of NI tied to assets or liabilities created through operating activities (ie: working capital) and adjusting to add or subtract changes in assets/liabilities accounts Use the balance sheet identity to determine whether or not to add or subtract from NI
The Accounting Cycle
1) Journalize: record each transaction as a journal entry in the general journal. 2) Post: transfer each journal entry to the appropriate T-account or general ledger. 3) Unadjusted trial balance: account balances are summed on a worksheet to verify that debits equal credits. 4) Adjusting Entries: update existing account balances to reflect deferred revenues and expenses and create new account balances to reflect unrecorded assets or liabilities and accrued revenues or expenses 5) Prepare financial statements: construct balance sheet, income statement, and cash flow statement with adjusted balances updated 6) Closing entries: close out all temporary and permanent accounts.
Liabilities
A liability is a claim on an asset by a "creditor" (a non-owners). It represent an obligation to make future payments of cash, goods, or services either to or on behalf of the creditor A liability is recognized when The obligation is based on benefits or services received currently or in the past. The amount and timing of payments is reasonably certain.
restructuring liability
A restructuring plan typically involves laying-off employees and incurring severance costs and turnover related expenses to training new replacements. This could also involve changes in capital allocations related to closing facilities, selling off property, etc. Even though the Blue Corps. hasn't yet had to restructure, it is applying the conservatism principle and recognizing this anticipated expense of future loss now.
Amortization
Accountants capture depreciation costs and treat them as an expense by "spreading out" the book value of a tangible asset (less the resale value) across the asset's anticipated use lifecycle. The process of "spreading out" a lump sum payment into a stream of payments is known as amortization.
Straight line depreciation
Accountants use a fairly simple procedure to uniformly amortize a depreciation expense over the usage lifecycle of the tangible asset known as "straight line" depreciation. This involves two steps: 1) Netting out the book value (original cost) of the asset by subtracting the resale (salvage) value. 2) Amortizing the resulting aggregate depreciation expense by spreading it out evenly (dividing it) over the usage horizon of the asset.
Closing out accounts Temporary Accounts
Accumulate the effects of transactions for a period of time only Revenue and Expense accounts Close out to Retained Earnings at the end of the period
Closing out accounts Permanent Accounts
Accumulate the effects of transactions over the entire life of business Balance sheet accounts Assets, Liabilities, Contributed Capital, Retained Earnings
Disagreement over FASB classification - taxes
All income tax effects are classified as operating activities even if the income is associated with financing or investing activities. EX: If we sell some PP&E for a gain, we must pay taxes on this investing activity but the tax collected shows up as an operating flow. FASB requires all cash taxes be disclosed as well so again, if you don't think that cash taxes should be part of "the operating picture," you can easily remove them
Assets
An asset is a resource that is expected to yield some future economic benefit by either Increasing future cash inflows Reducing future cash outflows An asset is recognized when It is acquired in a past transaction or exchange The value of its future benefits can be measured with a reasonable degree of precision
Depreciation
As an asset is utilized, the "wear and tear" on that asset has an associated replacement cost. In economics, we generally refer to such cost as depreciation. While depreciation is a real economic cost, it more often than not does not involve any explicit cash outflows. ie: everyday, the economics building wears down a bit from use, weather, etc., but there isn't any money being shelled out everyday to "pay" for these seemingly implicit costs
Balance Sheet Format
Assets are listed first in the following order: Current assets (benefits within next year) Ordered by liquidity (ease of conversion to cash) Cash Accounts Receivable Inventory Prepaid Assets Noncurrent assets Tangible Intangible Liabilities and Stockholders' Equity are listed next in the following order: Current liabilities (obligations with one year) Ordered by liquidity Bank debt Accounts payable and other payables Deferred revenues Noncurrent liabilities Bank debt and bonds Deferred Taxes Pensions, etc. Stockholders' Equity Contributed Capital Retained Earnings
Required Financial Statements
Balance Sheet Financial position at a particular point in time Income Statement Results of operating over a period of time Statement of Cash Flows Sources and uses of cash over a period of time Statement of Stockholder's Equity changes in stockholders equity over a period of time
Adjusting Entries
Before we can construct the income statement, we must make sure we've fully accounted for any expenses or revenues that have been incurred or accrued during the remaining operating window and update the journal and ledger (T-accounts) accordingly. Adjusting entries are internal transactions that update account balances before the conclusion of the accounting cycle. Entries must confirm with the accrual principles discussed with respect to recognizing revenues and matching expenses.
Financing Activities Cash Outflows
Cash Outflows Payment of dividends Purchase of treasury stock Payment of principal on debt Not interest payments!
Using ratios
Choosing an appropriate benchmark is important since Major changes within a firm distort time-series analysis Difference in business strategy, capital structure, or business segments distorts cross-sectional analysis. Differences in accounting methods across time or across companies also can distort time series and cross-sectional analysis.
Closing Entries - the final step in the cycle
Closing entries are internal transactions that "zero out" temporary accounts at the end of the accounting period. Revenue and Expense account balances are transferred to Retained Earnings Journal Entry for Revenues: Dr. Revenue Accounts (-R, -SE) Cr. Retained Earnings (+SE) Journal Entry for Expenses Dr. Retained Earnings (-SE) Cr. Expense Accounts (-E, +SE)
Revenue recognition (cont.)
Collection probability If you are uncertain of the collection of cash from a sale transaction, defer sale recognition until payment has been received Delivery is complete Ownership of the good must have shifted to the buyer as well as the risks of ownership. Persuasive evidence of an arrangement The substance of a transaction should indicate that a sale has indeed taken place. Simply consigning the goods without any terms/promise of payment does not constitute a sale. The price can be determined The buyer no longer as the contractual right to unilaterally terminate the contract and be paid back or reimbursed.
Operating Activities Cash Inflows
Collections from customers Receipts of dividends and interest earned from investments
Sources of Stockholders' Equity
Contributed Capital (selling new stock) Arises from the sale of shares of stock Retained Earnings Accumulation of net income from operating less earnings paid out to stockholders as dividends
4) Accrued expenses
Create new account balances to reflect unrecorded assets or liabilities Book the expense now for expected future cash outflow. Examples: Income Taxes Payable Interest Payable Salaries / Wages Payable Journal Entry: Dr. Expense Cr. Payable Liability
3) Accrued revenue
Create new account balances to reflect unrecorded assets or liabilities Book the revenue now for expected future cash inflow. Examples: Interest Receivable Rent Receivable Journal Entry: Dr. Receivable Asset Cr. Revenue
The Rule Makers (cont)
Generally Accepted Accounting Principles (GAAP) Established by the US Congress Delegated to the SEC Delegated to the Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) American Institute of CPA's (AICPA) Compliance to US GAAP is required for US firms
Accounting procedure (cont)
Depreciation is not deducted from the tangible asset's account. Instead, it is recorded in a Contra Asset Account (XA) called Accumulated Depreciation Normal balance is credit balance (this is opposite for a regular asset!) Is subtracted from PP&E on the balance sheet to get the "Net Book Value" of the operation (we will come back to this in our final preparation of the balance sheet and income statement) Amortization expenses for non-tangibles is often deducted directly from the intangible asset a
Investing Activities cash Inflows
Divestitures of businesses Sale of PP&E Sale of intangibles Sale of investments
Retained Earnings & Dividends
Dividends are just distributions of retained earnings to stockholders. Not treated as an operating expense (not linked to business/revenue activity) Changes in retained earnings are driven by the difference between net income earned from operating in a given period less dividends paid out to investors during that same period. That is, ∆𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
EBITDA, Earnings, and Cash Flows (cont)
EBITDA does not measure cash flow well if there are large changes in working capital. Suffers the same problem with respect to manipulating net income "channel stuffing" would increase earnings and EBITDA, but no cash is actually collected (but A/R would increase and this is a type of working capital account) In order to correct EDBITDA, we would have to "remove" (subtract) the recognized revenues (increase in A/R) from EBITDA to correct for this distortion.
EBITDA, Earnings, and Cash Flows
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is often used as a proxy for cash flow, but excludes interest and taxes (as well as non cash depreciation and amortized nontangible expenses). A proxy is a variable that is used to represent another variable, the latter of which may be generally unobservable or difficult to measure (ie: IQ and GPA are frequently used a proxy for intelligence). Since EBITDA it excludes interest and taxes, it is not subject to the issues discussed on the previous slide and is an extremely popular metric amongst analysts and investors alike.
Rules for debit and credit entries
Every transaction must have at least one debit and at least one credit Recall our earlier mention of "double entry" bookkeeping Debits must equal credits for all transactions Note this implies that the sum of debits must equal the sum of credits across all transactions Only non-negative numbers allowed
Expenses and matching
Expenses are decreases in Stockholder's Equity that arise in the process of generating revenues. Expenses are recognized when either 1) Related revenues are recognized Product costs OR 2) Incurred, if difficult to match with revenues Period costs or unusual events The matching principle is the idea that the expense should be matched with the business activity it is most closely related to.
Three types of accounting
Financial Accounting Tax Accounting Managerial Accounting
Journal entry format
For any transaction, we will always list the debit entries first, followed by the credit entries second. It is also common practice to indent the credit entries Here's an example of a typical journal entry for a generic transaction: Dr. <Name of Account Debited> $XXX.XX Cr. <Name of Account Credited> $XXX.XX
Salvage value
In computing the depreciation expense, we need to know what "part" of the book value of an asset is lost over the time horizon of use (we generally guess at this). Rather than trying to measure this directly, we instead look at the remaining "part" of the asset's value and estimate this by guessing at the resale value of the asset at the end of the use horizon. Note that we are essentially guessing at a future market value for a used tangible good The estimated resale value is often referred to as the salvage value of the tangible asset.
Relationship to Macroeconomic Theory
In macroeconomics, economists divide variables into two categories: Real variables Nominal variables Economists also divide up the time horizon into the Short run (when prices are "sticky" and cannot quickly adjust) Long run (when prices are "flexible" and have time to adjust to clear markets) The classical dichotomy is an idea that some variables are relevant (in terms of causal effects on others) in the short run, but not the long run.
Contributed Capital
Increases from issuance of new common stock Valued on the books at "par value" Additional paid-in-capital Excess over par value Treasury Stock Stock repurchases by the company
Intangible Assets
Intangible = Abstract Do not depreciate because there is no physical "wear and tear" Lump-sum cash outflow expenses are still amortized in accordance with the matching principle No accumulation is tracked for these types of assets Examples: software license, consulting services, etc...
IFRS
International Financial Reporting Standards (IFRS) Established by the International Accounting Standards Board (IASB) Required in over 100 countries Not applicable to US firms filing in the United States Despite being different than GAAP, the overlap between the two rule sets are large enough that we can ignore most differences at the introductory financial accounting level
Financing Activities Cash Inflows
Issue of new stock Re-issue of treasury stock Taking on debt / loan
An empirical result
It is a well established result in academia that earnings are a better predictor of future cash flow than current cash flow from operations. This is because earnings is attempting to measure the creation of value. Are you able to price your product at a societal value that covers the cost of providing it (ie: the cost of doing business)? High earnings today are indicative of high cash flows in the future even if it turns out that the operation isn't generating high cash flows today. Using both earnings and cash flow (both pieces of information) together provide the best forecast of future cash flows.
A brief summary
Journal entries and T-accounts, together, are used to track transactions. The balance sheet identity must always hold. The sum of debits must equal the sum of credits for a transaction. Debits = "Left-side" entries and increases (decreases) balances of debit (credit) accounts. Credits = "Right-side" entries and increases (decreases) balances of credit (debit) accounts. Assets and Expenses have normal debit balances. Liabilities, Shareholders' Equity, and Revenues have normal credit balances.
Direct Method
Lists cash receipts and disbursements by source/use of funds Always used for putting together Investing activities portion of cash flow statement Financing activities portion of cash flow statement Rarely used for operating activities! GAAP has a requirement that the indirect method always be used for operating activities, but the direct method can also be used. As a result of the abovementioned requirement, most companies use only the indirect method for describing the operating activities portion of the cash flow statement. Using the direct method will still require the firm to also apply the indirect method. A good check, but somewhat redundant effort.
Internal Reporting
Management is responsible for preparing financial statements. With oversight from the Audit Committee of the Board of Directors (BoD) Independent auditors are hired by the BoD to provide a formal "expressed opinion" regarding the financial statements' conformity with GAAP.
Disagreement over FASB classification - interest
Many investors and analysts prefer to classify interest payments as financing activity rather than as operating activity. Many investors and analysts also prefer to classify interest and dividends received as an investment activity rather than as an operating activity. Recall under IFRS, you would in fact have the ability to do this (but not under GAAP), making some additional flexibility to do the same under the FASB classification facilitate an advantage when it comes to benchmark comparability in looking at a cross-section of firm performance internationally. We will discuss some issues with benchmarking in the next few lectures Cash paid for interest must be disclosed, so if investors or analysts want to take it out of operating activities, they can easily subtract it because the disclosure is provided.
Straight line depreciation Mathematics
Mathematically, the depreciation expense in a given accounting period will be computed as 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒=(𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 −𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒)/(# 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑎𝑠𝑠𝑒𝑡^′ 𝑠 𝐿𝑖𝑓𝑒 𝐶𝑦𝑐𝑙𝑒)
Key features of the balance sheet identity
Must always balance so that a change in one side of the equation necessarily implies a change in the other side. this imposes the necessity of double-entry bookkeeping as we will see shortly when we look at how debits and credits are logged in journal entries for bookkeeping purposes The changes between two periods' balance sheet activities are summarized in the Income Statement, Statement of Stockholder's Equity, and Statement of Cash Flows.
Free Cash Flows - many different definitions
Net operating profits less adjusted taxes (NOPLAT) 𝑁𝑂𝑃𝐿𝐴𝑇=𝐸𝐵𝐼𝑇𝐷𝐴−𝐶𝑎𝑠ℎ 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑 𝑜𝑛 𝐸𝐵𝐼𝑇𝐷𝐴 Net operating profit after taxes (NOPAT) 𝑁𝑂𝑃𝐴𝑇=𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒+𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥 𝑛𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 Net income adjusted for depreciation and other noncash items (less increase in net working capital) After-tax EBIT + Depreciation =𝐸𝐵𝐼𝑇(1−τ)+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 Earnings before interest, taxes, depreciation, & amortization (EBITDA) Cash from operations before interest expense...and more!
Nominal variables
Nominal variables: Measured in money units, e.g., nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future by lending one dollar today. the price level: The amount of dollars needed to buy a representative basket of goods
Indirect Method
Not used for Investing cash flows Financing cash flows Applies only to cash flows associated with operating activities! The objective of the indirect method is to reconcile net income with operating cash flows by Removing noncash items from net income Depreciation, amortization, etc. Including additional cash flows not in net income Changes in accounts receivable, inventory, accounts payable, etc. Most widely used method for preparing the operating activities portion of the statement of cash flows.
Operating Activities Cash Outflows
Payments to non-labor inputs / suppliers Payments to labor / employees Payments made on interest obligations Not principal! Payments made on tax obligations Other disbursements related to business operations
Ratios
Ratios are useful in assessing features of a firm including (but certainly not limited to) profitability, liquidity, and risk. Highlight sources of competitive advantages Identify potential trouble Ratios must be compared to a benchmark (ie: control group) Compare the same firm at different points in time Time series analysis Compare the firm to other firms in the industry Cross-sectional analysis
Real variables
Real variables: Measured in physical units - quantities and relative prices, for example: quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today
Accrual Accounting
Recognition of revenues and expenses are tied to business activities. This may differ dramatically from cash flow activity (as we saw with Bill's internet security example). 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠≠𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 In general, accrual basis is much more popular and widely used than is cash basis, but both are legitimate. Revenues are recognized when goods and services are provided, not necessarily when payment is received. This untangles revenues from cash inflows Must apply the revenue recognition criteria.
Investing Activities
Related to acquisition or disposal of long-term assets
Financing Activities
Related to owners or creditors With the exception of interest payments
Operating Activities
Related to providing goods and services to customers Note that dividends and interest received are considered operating cash flows (and not investing cash flows). The case could certainly be made that these are investing (and not operating activities). However, the FASB decided to include these as part of operating cash flows for comparability to the income statement. The operating cash flows portion of the statement of cash flows should be thought as an analog to the income state Operating cash outflows exclude the following income statement items: Depreciation and amortization (and other noncash items) Gains or losses on disposal of PP&E
Statement of Cash Flows
Reports inflows and outflows of cash due to operating, investing, and financing activities over a period of time. Rough Format: 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 + 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 + 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 𝑁𝑒𝑡 Δ 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 Any non-cash transactions must be disclosed at the bottom of the statement We saw an example before where a company traded a building for a piece of land in a completely cashless transaction. Any interest obligations paid in cash must be disclosed. Any tax obligations paid in cash must be disclosed.
Revenue recognition (GAAP)
Revenue is an increase in Stockholder's Equity from providing goods or services. In accrual accounting, revenues are recognized when both of the following conditions are met: 1) It is earned Goods or services are provided / rendered 2) It is realized Payment for goods or services received in cash or something that can be converted to a known amount of cash.
General format of Income Statement
Revenues Cost of Goods Sold (COGS) Gross Profit Operating (SG&A) Expense Operating Income Interest, Gains, and Losses Pre-tax Income Income Tax Expense Net Income
Accrual Accounting
Revenues are recognized when goods and services are provided, not necessarily when payment is received. This untangles revenues from cash inflows Must apply the revenue recognition criteria. Expenses are recognized in the same period as the revenues they facilitated. This untangles expenses from cash outflows. Apply the matching principle
The balance sheet
The balance sheet takes into account of the "stock" (not like stocks and bonds) of resources the firm utilizes. It also accounts for any claims on these resources by all stakeholders. The fundamental equation in accounting is given the following accounting identity, often referred to as the balance sheet equation: 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦
cash flow complications
Sometimes the change in the balance sheet numbers often do not equal the corresponding number on the statement of cash flows. There are several reasons why something like this could occur. 1) Noncash investing and financing activities 2) Acquisitions and divestitures of businesses 3) Foreign currency translation adjustments 4) Subsidiaries in different industries
Cross-industry subsidiaries
Sometimes, companies have subsidiaries in different industries (and different countries!) If the line of business is dramatically different across subsidiaries, then the operating classification of an activity could differ between subsidiaries depending on what the "main" line of business is. Ex: Suppose a pharmaceutical company purchases a real estate subsidiary. If the pharmaceutical company purchases land, it would be considered an investing activity. If the real estate subsidiary purchases the property, it would be classified as an operating activity (due to the nature of the real estate entity's main line of business).
Debits, credits, and the balance sheet
Starting with our balance sheet identity 𝐴𝑠𝑠𝑒𝑡𝑠=𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠+𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟^′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 and decomposing to the "complete" balance sheet identity yields 𝐴𝑠𝑠𝑒𝑡𝑠= 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠+𝐶𝑜𝑛𝑡. 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑡. 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠+𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 −𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 Moving Expenses to the left hand side so that all terms are added (and no subtraction is taking place) on all sides yields 𝐴𝑠𝑠𝑒𝑡𝑠+𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠= 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠+𝐶𝑜𝑛𝑡. 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑡. 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠+𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠
Adjusted Trial Balance
Summarizes balances in each account after adding in any adjusting entries. Used to prepare the financial statements
Unadjusted Trial Balance
Summarizes the balances in each account before adding in any adjusting entries. Used only as an intermediary step in preparation of financial statements
Tangible Assets
Tangible = Physical Depreciation should be accounted for The expense should be amortized The accumulated depreciation is also tracked Examples: office equipment, hardware, buildings, other PP&E expenditures...
Accounts and balance formats
The "type" of account balance (debit or credit) carried by a particular account under regular circumstances is often referred to as the account's normal balance. A T-Account is a formal record of all changes in an accounting quantity Debits entries are listed on the left side of the T Credit entries are listed on the right side of the T An account balance is just the difference between the sum of debits and sum of credits for the account
External Enforcement & Oversight
The SEC (as well as other regulators) can take legal action should any GAAP non-conformities or other violations come to light. Information intermediaries and may help to expose firms with questionable accounting. Media coverage Stock analyst reports Institutional investors fleeing General public oversight
Financial Reporting
The Securities and Exchange Commission (SEC) requires reporting/filing at regular intervals to be prepared in accordance with Generally Accepted Accounting Principles (GAAP): 10-K, Annual Report 10-Q, Quarterly Report 8-K, Current Report (material events) Much of the tension in financial accounting is caused by meeting deadlines associated with these periodic filing requirements.
The balance sheet identity
The fundamental equation in accounting is given the following accounting identity, often referred to as the balance sheet equation: 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 = 𝐶𝑙𝑎𝑖𝑚𝑠 𝑜𝑛 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝑏𝑦 𝑜𝑢𝑡𝑠𝑖𝑑𝑒𝑟𝑠 𝑎𝑛𝑑 𝑜𝑤𝑛𝑒𝑟𝑠
Stockholders' Equity
The residual claim on assets after settling claims with creditors. It can be though of as the net value of the assets after netting out the "expense" associated with liabilities 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠^′ 𝐸𝑞𝑢𝑖𝑡𝑦=𝐴𝑠𝑠𝑒𝑡𝑠 −𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Also referred to as "net worth," "net assets," and "net book value"
Free Cash Flows
The term free cash flow (FCF) generally refers to the amount of cash flow generated from operations less funds tied up in long-term investments. It is useful when asking the question, what is the economic value of the entire operation? How much is a share in the common stock worth? you will tackle this issue extensively in corporate finance) Unfortunately, there really isn't a standard textbook measure or definition for a free operating cash flow. As a result, companies often disclose free cash flow estimates using their own definitions (which of course are provided).
depreciation Other methods?
There are other methods of reporting depreciation on assets. This is just one of them (the simplest and most commonly applied). Unfortunately, the straight line treatment doesn't tend to actually match the rate at which assets depreciate in reality in terms of their true economic cost. Other methods of recording depreciation (ie: MACRS) are implemented to more accurately match the depreciation expense to the actual economic costs implied by the asset "wear and tear." There may be tax advantages to logging hire expenses earlier in the life cycle of an asset than later (ie: a tax shield - we might discuss this later and you'll definitely talk about this in Corporate Finance).
The Rule Makers
There are two important sets of governing bodies to be aware of when it comes to financial accounting. Generally Accepted Accounting Principles (GAAP) International Financial Reporting Standards (IFRS)
Accrual vs. Cash Basis
There are two methods for accounting for sales and expenses that are used widely and are both acceptable. Accounting for revenues and expenses on a cash basis entails recording revenues and expenses only when money is received and paid out, respectively. Very similar to how we look at cash flows Accounting for revenues and expenses on an accrual basis entails recording revenues and expenses only when they are earned and incurred, respectively. Need to be clear about what is meant by earned and incurred
Noncash investing & financing activity
There could be non-cash investing and financing activities related to working capital accounts in the operating section of the SCF.
Noncash investing & financing activity continue
There could be non-cash investing and financing activities related to working capital accounts in the operating section of the SCF. Ex: Suppose customer owes for payment, but can't pay in cash so decides to pay with a piece of land. Disclosed at the bottom of SCF Ex: You owe your supplier payment and instead of paying cash, provide an additional service as noncash compensation. Again, disclosed at the bottom of the SCF
Net PP&E Account
There isn't really such thing as a net PP&E account in the real world. This is just a simplification for now - the actual journal entry would have you do the following: 1) credit the building account for the book value of the building at the time of purchase 2) debit the accumulated depreciation account for all the depreciation that's accumulated for the building up to this point (information we don't have in this example - hence the simplification).
Liabilities, stockholder's equity, and revenue accounts
These accounts carry a normal balance as credit (let side of T) balance Debit transactions will decrease the account balance Credit transactions will increase the account balance Here's an example with Accounts Payable:
Asset and expense accounts (the left side)
These accounts carry a normal balance as debit (let side of T) balance Debit transactions will increase the account balance Credit transactions will decrease the account balance Here's an example with Accounts Receivable:
Foreign currency translation adjustments
This is relevant to multinational companies that have subsidiaries in multiple countries utilizing multiple currencies. The idea is to take any effect of exchange rate fluctuations and "remove" them out of the operating section of the cash flow and disclosing them at the bottom of the SCF. That is, a FOREX (foreign exchange) movement could effect the balance of accounts receivable or inventory on the balance sheet, but we wouldn't show it in the operating activities portion of the SCF. Exchange rate movements are generally representative of nominal economic activity (like a change in the units of measurement; ie: the dollar) - it is not capturing real (measured in output produced) economic activity which is why we want to remove these effects from the operations section.
Treatment of FOREX Fluctuations in SCF
Treatment of FOREX Fluctuations in SCF: These are representative of the relative price levels (nominal variables) changing between countries and hence, shouldn't affect any real market activity. We treat these fluctuations as if they are long run phenomena
Typical Current Assets
Typical Current Assets Cash Marketable Securities (short-term, liquid investments) Accounts Receivable (amounts owed by customers on sales) Notes Receivable (amounts owed by noncustomers on loans) Interest Receivable (accrued revenue not yet received in cash) Inventory (costs of goods available for sale) Prepaid Expenses (rent, insurance, etc.—deferred expenses
Typical Liabilities
Typical Liabilities Accounts Payable (amounts owed to suppliers on purchases) Notes Payable (or mortgage payable—amounts owed to creditors [banks] on loans—could be current or noncurrent) Accrued Payables (or Accrued Expenses) (wages, salaries, interest, dividends, taxes, warranties, etc.—accrued expenses not yet paid in cash) Unearned Revenue (also advances from customers— deferred revenues)
Typical Long-Term Assets
Typical Long-Term Assets Land (tangible asset, not depreciated) Buildings, Equipment (tangible assets that are depreciated) Accumulated Depreciation (contra asset—sum of past depreciation) Investments (long-term investments) Notes Receivable (could also be noncurrent) Intangible assets (patents, goodwill, etc.)
Typical Stockholders Equity
Typical Stockholders Equity Common Stock (at Par) (Shares issued times par value) Additional Paid-in-Capital (Shares issued times [market price - par value]) Retained Earnings (Equals prior retained earnings plus revenues minus expenses minus dividends)
1) Deferred revenues
Update existing account balances to reflect current accounting values Cash inflow in past and need to book the revenue now Examples: Unearned rental revenue Unearned revenue on a long term service contract Deferred subscription revenue Journal Entry: Dr. Unearned Revenue Liability Cr. Revenue
2) Deferred expenses
Update existing account balances to reflect current accounting values Cash outflow in past and need to book the expense now Examples Prepaid rent Prepaid insurance Software license Legal counsel Depreciation or amortization Journal Entry: Dr. Expense Cr. Prepaid Asset
Acquisition and divestitures of business entities
When one company acquires another, all the cash the acquiring company pays is considered an investing cash flow activity. However, part of the acquisition portfolio often includes working capital assets and liabilities. Those accounts receivable would show up on the balance sheet, but would not be part of the number in the operating section portion of the SCF. Since we have already classified the acquisition/divestiture as an investing cash flow, we don't want to double count it so we must "adjust" to remove the effects.
Conservatism principle
When recognizing costs and benefits, it is always best to err on the side of caution. This involves immediately recognizing anticipated losses vs. delaying the record of the expense until after the loss is realized. This involves recognizing anticipated gains only when they are realized and not in advance. Doing both of these things will result in an upward bias on the cost side and a downward bias on the benefit side ensuring a reasonably conservative estimate
Working Capital
Working capital is defined as: 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙= 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 It includes the following (and more) noncash elements/accounts: Accounts Receivable Accounts Payable Inventory Prepaid Expenses Interest Payable ... Working capital constitutes the set of assets and liabilities over which management exercises the most control (aside from liquid cash).
IFRS Differences - dividends and interest
operating activities inflow receipts of interest and dividends on investments outflow Payment of Interest Financing activities outflow Payments of dividends
The Classical Dichotomy
real variable nominal variable the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables in the long run (but may in the short run).
Decomposing the balance sheet identity
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 +𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑃𝑟𝑖𝑜𝑟 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠+𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 −𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 −𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
