FINANCIAL REPORTING AND PERFORMANCE MEASUREMENT

Week 1 - 19 September 2022

AMAZON
His recent stock price: 123,17$
 Stock price: it tells you a company current’s value or its market value. It represent how much the stock
trades (il titolo viene scambiato) and/or the price agreed upon (concordato) by a buyer and a seller.
- Buyer > Seller: the stock’s price will climb (sale il prezzo delle azioni)
- Buyer < Seller: the price will drop (diminuisce il prezzo delle azioni
Question about a stock price:
 Is this the correct price? ---
 Is it over valued or undervalued? ----
 Will the company grow? ----

ACCOUNTING
Managers (internal decision makers) need information about the company’s business activities to manage
the operating, investing, and financing activities of the firm. Stockholders and creditors (external decision
makers) need information about these same business activities to assess whether the company will be able
to pay back its debts with interest and pay dividends.
= All businesses must have an accounting system that collects and processes financial information about an
organization’s business activities and reports that information to decision makers.

Accounting: is a system that collects and processes (analyzes, measures, and records) financial information
about an organization and reports that information to decision makers.

Types of accounting:
1) Financial Accounting
Financial accounting reports (periodic financial statements and related disclosures) provided to
external decision makers (creditors and investors) who evaluate the company
 Output: Financial statements
 Users: Investors, Shareholders, Creditors
 Structure: Regulated, Regimented

2) Managerial Accounting
Managerial accounting reports (detailed plans and continuous performance reports) provided to
internal decision makers (managers) who run the company.
 Output: Budgets, Cost Reports, Variance Reports, Ad-hoc Analyses
 Users: Management
 Structure: Loose, Flexible

What Types of Decisions do Financial Statements Help Investors and Creditors Make?
1. What are the likely Future Cash Flows?
2. What is the firm’s Value?
3. Are there any Red Flags that are a cause of concern?
4. What are the Risks and Uncertainties that are present or likely to arise?
5. What is the likelihood that the company will generate enough cash to Repay a Loan on a timely basis?
6. How well is Management performing?
7. Is the New Strategy working?
8. Does the company have enough Resources to expand?
Accrual Accounting and Estimates
When preparing consolidated financial statements according to Generally Accepted Accounting Rules
(GAAP) or International Financial Reporting Standards (IFRS) we use estimates and assumptions, because
we don’t have always the right numbers.
These affect our reporting amounts of assets, liabilities, revenues, and expenses, as well as related
disclosures of contingent assets and liabilities
In some cases, we could reasonably have used different accounting policies and estimates. In some cases,
changes in the accounting estimates are reasonably likely to occur (è rotabile che si verifichino) from
period to period.
Accordingly, actual results could differ materially from our estimates.
Practically people can simply manipulate financial assumption, but this is not legal.

Basic concepts
Assumption (presupposto)
 Separate entity assumption = states that business transactions are separate from the transactions
of the owners.
 Going concern assumption (continuity assumption) = States that businesses are assumed to
continue to operate into the foreseeable future
 Monetary unit assumption = States that accounting information should be measured and reported
in the national monetary unit without any adjustment for changes in purchasing power.
THE FOUR BASIC FINANCIAL STATEMENTS
The four basic financial statements are prepared by profit-making organizations for use by investors,
creditors, and other external decision makers. Those can be prepared at any point in time (such as the end
of the year, quarter, or month) and can apply to any time span (such as one year, one quarter, or one
month). Like most companies, these are prepared for external users (investors and creditors) at the end of
each quarter (known as quarterly reports) and at the end of the year (known as annual reports).

1. The Balance Sheet (bilancio): reports the financial position (amount of assets, liabilities and
Stockholders’ equity) of an entity at a point in time (for example 31/12/2020). Snapchat of a precious
situations. \
2. The Income Statement (conto economico): reports the revenues, expenses, and net income. More
specifically it reports revenues less the expenses of an entity for an accounting period (a quarter, a
year). It is how a company performe, it is the difference between revenues and costs.
3. The Cash Flow Statement (rendiconto finanziario): reports the cash inflows and outflows of an entity
during an accounting period in the categories of operating activities, investing activities, and financing
activities for an accounting period (a quarter, a year). It shows the change of cash in a year.
4. The Statement Of Shareholders’ Equity (prospetto di patrimonio netto): contains the Statement of
Retained Earnings which shows the amount of net income that the entity chose to retain in the
business and the amount it elected to pay out as dividends; shows changes in the equity accounts. It
shows how the equity change, and this means that this is the difference between total assets and total

liabilities.
THE BALANCE SHEET
The balance sheet has the purpose of reporting the financial position (assets, liabilities and stockholders’
equity) of an accounting entity at a particular point of time.
Accounting entity: the organization for which financial data are to be collected.
The basic accounting equation (balance sheet equation)

Assets: economic resource that a company

has.
Liabilities (debiti) and Stockholders’
equity (azioni): how the company finance
these resources

Perché sono importanti Asset, liabilities and stockholders?

- Asset: fanno capire se la compagnia ha risorse sufficienti per operare. Per capire nel caso in cui l’azienda
fallisca quanti asset possono essere venduti per ricavare denaro per i creditori.
- Liabilities: per capire se ci siano abbastanza risorse per pagare i debiti e per le banche per prestare soldi
alla compagnia.
- Stockholders: importante per la banca perché le richiesti dei creditori sono più importati di quelle dei
soci. Se l’azienda fallisce i suoi asset sono venduti e vengono pagati per primi i creditori e poi gli
stockholders.

ASSETS (patrimonio)
They are the economic resource that a company has. Assets are probable future economic benefits owned
or controlled by an entity as a result of past transactions or events.
An asset must satisfy all the following:
 It has a probable future economic benefit that can be reliably measured or estimated.
 The firm controls (owns) it.
 Its acquisition (ownership) is based on a current or past transaction or event.

How are Assets carried on the books?

 Market value: it is the projected value of an asset in the market and it indicates its profitability. The
value is determined by the market participation. (Valore di mercato del prodotto, ipotizzato per capire i
probabili profitti)
 Historical cost: it is the price paid for an asset when it was purchased. (Prezzo effettivo di vendita)

Order of presentation
v Current Assets: Cash; Marketable Securities (or Investments); Accounts Receivable (A/R) = crediti verso
clienti): sales of an account, for ex you buy a computer and you pay it month for month this is the
future value that the company will obtain; Inventories (inventario) = a complete list of items that the
company have to sell hat is considered a current asset regardless of the time needed to produce and
sell it; Prepaid Expenses.
Assets that will be used or turned into cash within one year.
v Non-Current Assets: Machinery and Equipment; Buildings; Land
v Investments: Securities (Equity or Debt)
v Intangibles: Patents; Copyrights; Brand Names; Deferred Charges; Goodwill
Ricorda: Every asset on the balance sheet is initially measured at the total cost incurred to acquire it.
Balance sheets do not generally show the amounts for which the assets could currently be sold. (Ogni
attività in bilancio è inizialmente valutata al costo totale sostenuto per acquisirla. I bilanci generalmente
non mostrano gli importi per i quali i beni potrebbero essere attualmente venduti)
LIABILITIES (passività)
They are the amount of financing provided by creditors (debts and obligations).
Probable future sacrifices of economic benefits arising from a present obligation to transfer cash, goods, or
services as a result of a past transaction. When you close the financial statement you have liabilities.
A liability must satisfy all the following:
 It entails a probable future economic sacrifice that can be reliably measured or estimated.
 The firm is obligated to pay it (that is, it “owns” the liability).
 Its incurrence (“ownership”) is based on a current or past transaction or event.

Order of presentation: in order of maturity (how soon an obligation is to be paid).

v Current liabilities: Accounts Payable to suppliers (A/P); Notes Payable (N/P); Expenses Payable;
Deferred revenue = advance payments a company receives for products or services that are to be
delivered or performed in the future; Short term Loans (debt), Current portion of long-term loan,
Unearned Revenue (for unredeemed gift cards that have been purchased by customers), Income Taxes
Payable (owed to federal, state, and local governments), and Accrued Expenses Payable (more
specifically, Wages Payable and Utilities Payable, although additional accrued liabilities may include
Interest Payable, among others).
Short-term obligations that will be paid in cash (or other current assets) within the current operating
cycle or one year, whichever is longer.
v Non-current liabilities: Long term Bonds and Loans (debt)

STOCKHOLDERS’ EQUITY (patrimonio azionisti; “attivo”) /SHAREHOLDERS’ EQUITY/ OWNERS’ EQUITY

Stockholders’ equity is the amount of financing provided to the company by its owners.
It is the residual claim on the firm’s assets, held by the firm’s stockholders.
If we rearrange the Accounting Identity: Equity = Assets – Liabilities.

Stockholders’ Equity is the:

Financing Provided by Owners is referred to as contributed capital
Financing Provided by Operations is referred to as earned capital or retained earnings.

 Contributed capital (direct investment by the owners): when a company issue shares to the market any
proceeds from the sale go into “contributed capital”. It is the cash and other assets that shareholders
have given a company in exchange for stock. (Contante dato in cambio di azioni, conferimenti in
denaro).
Generally, the contributed capital is characterized by two components:
Contributed capital = common stock + additional paid-in-capital
a) Common stock = is the par value of issued shares (is the investment of cash and other assets in the
business by the stockholders)
b) Additional paid-in capital = represents money paid by the shareholders of the company above the
par value of the company. The amount of contributed capital less the par value of the stock.
Contributed capital is raised by the company by selling stock in the market through the initial and
subsequent public offerings.
There is one type of events that cause the contributed capital accounts to change, and it is the buyback
of the shares by the company.

Qual’è la fonte (source) di common stock e additional paid-in-capital?

L'importo indicato in additional paid-in-capital e l'importo indicato in common stock: were raised by
the company by selling stock in the market through the initial and subsequent public offerings
 (sono stati raccolti dall'azienda vendendo azioni sul mercato attraverso l'offerta pubblica iniziale e
quella successiva)

VEDI BENE CON LUDO TUTTO PARAGRAFO DELLA STOCKHOLDERS EQUITY

 Earned capital/Retained earnings (indirect investment by the owners): is the amount of earnings
(profits) reinvested in the business (and thus not distributed to stockholders in the form of dividends)
(Utili non distribuiti o riserve). it is the accumulated earnings of the firm since its inception minus any
dividends declared to shareholders. (Sono gli utili ottenuti dopo aver sottratto gli eventuali dividendi da
dare agli azionisti).
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠t = 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛gst-1 + 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒t − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝐷𝑒𝑐𝑙𝑎𝑟𝑒𝑑t – Stock
Buybackst (or Share repurchasest).

> In this case there is a share buyback: every shareholder has a dividend which is taxed, the
shareholder can choose if he wants to partecipate in the buyback. The company thinks that the shares
are undervalued in the market. We have a share buyback because he company buy back its own shares
(azioni) from the market place because the company has cash on hand and the market is growing,
infact here the previous year we have more retained earnings than the current year because we use
that retained to buy back stock infact at the current year we have less retained earnings.
Question to think about:
- If the stock prices changes and it goes up by 15% what happen to equity? Nothing because when
the market prices stock changes nothing happens to the equity.
- Can retained earnings be negative? Yes if company loses money.
- Can Total Equity be negative? No, because it means that your assets are minor than your liabilities.
In this case the company will fail.
UBER: keep operating with negative equity, it do it because it see possible profit in the future so its
important to reach this goal.

 Other Comprehensive Income (OCI) SONO GLI STESSI DELL’INCOME STATEMENT?

“BOOK VALUE OF EQUITY”

It the amount of cash remaining once a company's assets have been sold off and if existing liabilities were
paid down with the sale proceeds.
Book value of equity = total asset – total liabilities
WHAT BUSINESS ACTIVITIES CAUSE CHANGES IN FINANCIAL STATEMENT AMOUNTS?
Accounting focuses on certain events (external or internal) that have an economic impact on the company.
Those events are called transactions.
Transaction definition: (1) An exchange between a business and one or more external parties to a business
or (2) a measurable internal event such as the use of assets in operations.

How do transaction affect accounts?

Transaction effects increase and decrease assets, liabilities, and stockholders’ equity accounts (only
transactions affecting cash are reported on the statement).
To accumulate the dollar effect of transactions on each financial statement item, organizations use a
standardized format called an account.
Accounts definition: A standardized format that organizations use to accumulate the dollar effect of
transactions on each financial statement item.
Transaction analysis: the process of studying a transaction to determine its economic effect on the entity
in terms of the accounting equation (also known as the fundamental accounting model).
Assets (A) = Liabilities (L) + Stockholders’ Equity (SE), every transaction affects at least two accounts.
Example of dual effect of transaction:
 For example if we purchase something we increase our assets but we have more liabilities (accounts
payable increase) because we do a promise to pay later
 For example if we do a payment of cash to the suppliers we decreased our account liabilities because
the promise of payment is eliminated and we have cash decreased.

The direction of transaction effects

As we saw earlier in this chapter, transaction effects increase and decrease assets, liabilities, and
stockholders’ equity accounts. Each account is set up as a “T” with the following structure:
- Increases in asset accounts are on the left because assets are on the left side of the accounting
equation (A = L + SE).
- Increases in liability and stockholders’ equity accounts are on the right because they are on the right
side of the accounting equation (A = L + SE).

Ricorda:
o The term debit always refers to the left side of the T (account).
o The term credit always refers to the right side of the T (account).
Asset accounts increase on the left (debit) side and normally have debit balances.
It would be highly unusual for an asset account, such as Inventory, to have a negative (credit) balance.
Liability and stockholders’ equity accounts increase on the right (credit) side and normally have credit
balances.
How do companies keep track of account balances?
 ACCOUNTING CYCLE = the process used by entities to analyze and record transactions, adjust the
records at the end of the period, prepare financial statements, and prepare the records for the next

cycle.

Determine the impact of business transactions on the balance sheet using two basic tools: journal entries
and T-accounts:
 Journal entries express the effects of a transaction on accounts in a debits-equal-credits format.
The accounts and amounts to be debited are listed first. Then the accounts and amounts to be
credited are listed below the debits and indented, resulting in debit amounts on the left and credit
amounts on the right. Each entry needs a reference (date, number, or letter).

 T-accounts summarize the transaction effects for each account. These tools can be used to
determine balances and draw inferences about a company’s activities.
FINANCIAL RATIOS BASED ON THE BALANCE SHEET DA SISTEMARE TUTTO, SPIEGA A PAROLE
It is a quick way to obtain valuation; the best way to talk about ratios is to start with whatever is in the
denominator and say: “For every dollar of [denominator], there is XXX in the [numerator]”.
total liabilities
Example: = 0.65 = for every dollar of assets that the company has, 65 cents has been funded
total assets
by liabilities.

Ratios (= rapporti fra due grandezze) are:

v Liquidity
Current ratio measures the ability of the company to pay its short-term obligations with current assets.
Although a ratio above 1.0 indicates sufficient current assets to meet obligations when they come due,
many companies with sophisticated cash management systems have ratios below 1.0

current assets
Current Ratio =
current liabilities

Current ratio measures the ability of the company to pay its short-term obligations with current assets.
o If Current Assets > Current Liabilities, then Ratio is greater than 1.0 -> a desirable situation to be in.
o If Current Assets = Current Liabilities, then Ratio is equal to 1.0 -> Current Assets are just enough to
pay down the short term obligations.
o If Current Assets < Current Liabilities, then Ratio is less than 1.0 -> a problem situation at hand as
the company does not have enough to pay for its short term obligations.

Example:  if company C has $2.22 of Current Assets for each $1.0 of its liabilities; company C is more
liquid and is better positioned to pay off its liabilities.

(cash∧cash equivalents+account receivables)

Quick Ratio =
current liabilities

The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s
ability to meet its short-term obligations with its most liquid assets. The higher the ratio result, the
better a company's liquidity and financial health; the lower the ratio, the more likely the company will
struggle with paying debts.
o A company having a quick ratio higher than 1 can instantly get rid of its current liabilities
o A result of 1 is considered to be the normal quick ratio. It indicates that the company is fully
equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities.
o A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities
in the short term.

Example: a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each
$1 of its current liabilities.
v Debt (or Capital Structure Ratios)
The relative amount of debt used by a company is an indication of its financial risk. More debt means
that the company has more fixed finance charges (interest) that it must pay regardless of its
profitability (or lack thereof), raising the prospects of default and bankruptcy.

total liabilities
Debt-to-Assets Ratio =
total assets

“For every dollar of assets, the liabilities equal X, or about (X%) cents. Those to whom the company
owes money (the lenders, suppliers, employees, etc.) have provided (X%) cents in funding for every
$1.00 of assets”

total liabilities
Debt-to-Equity Ratio =
total equity

v Growth Expectations (valore che esprime quanto l’azienda cresce sul mercato)

market value of equity (¿ Market Cap )

Market/Book Ratio =
book value of equity

Se il market value non ce l’hai, si trova facendo: Market Value = price * number of shares outstanding

WORKING CAPITAL (capitale circolante netto)

It is the dollar difference between total currents assets and total current liabilities.
The working capital accounts are actively managed to achieve a balance between a company’s short-term
obligations and the resources to satisfy those obligations. (Il capitale circolante è gestito per raggiungere
un equilibrio tra gli obblighi a breve termine e le risorse per soddisfarli).
A useful measure that indicates how much capital is used in day-to-day operations. It is a dollar amount.
It can be measured as either:
 Option1: Working capital = current assets−current liabilities
 Option 2: Working capital = cash +account receivable+ inventory−account payable
working capital
o You can also look at: = “for every dollar in total asset the company has to give X dollar
total assets
in working capital”

Question:
- What is the optimal level of working Capital? It depends on the company.
- Can it be negative? Working capital could be negative, for example amazon has it beacuse it have a lot
of accounts payable (tanti debiti) and less cash.

The case of Dell Computers

INTERPRETING FINANCIAL RATIOS - Benchmarks
Two standard benchmarks:
1. The same company in previous periods
2. Companies in the industry in which the company operates

Caution:
 The company itself could change from one period to the next.
 The accounting estimates or principles being used could change
 The comparison companies might have similar changes.

LIMITATIONS OF RATIOS

current assets 40,000

1) Example: Current Ratio = = = 2.0
current liabilities 20,000

 How do you read this ratio? ------

 Is the company liquid? Not necessarily because it could be inventory if it is not liquid.

(cash∧cash equivalents+account receivables) 20,000

2) Example: Quick Ratio = = = 1.0
current liabilities 20,000

 How do you read this ratio? ----

 Is the company liquid? Not necessarily, beacause we don’t know what happens is going on with the
company
 What is the conclusion from this? -----

Ratios can be manipulated

3) Example:
Current Assets = 250.0
Current Liabilities = 200.0
Current Ratio = 1.25
Loan Covenant: Company must maintain a Current Ratio of at least 1.30
 To achieve the required ratio, the company pays its supplier 75 in cash.
Cash decreases by 75 and Accounts Payable decreases by 75.
Current Assets = 175.0
Current Liabilities = 125.0
Current Ratio = 1.40
Week 2 - 26 September 2022

THE INCOME STATEMENT

If the Balance Sheet is a “snapshot” of the firm at a given date, the Income Statement is a description of
the performance of the firm throughout the accounting period (a quarter, a year). It reports the revenues
less the expenses of the accounting period.

The elements of the Income Statement:

REVENUES (Revenues = Expenses + Net Income)

Revenues represent the amount that come from the sale of goods or service to customers.
Revenues represent an increase in assets or settlements of liabilities from the major or central ongoing
operations of the business.

They can be divided into:

 Operating revenues = are the revenue generated from the major or regular ongoing operations of the
business. They result from the sale of goods
 Non-operating revenues = are the additional revenue generated through other activities like rent,
dividends, etc..

Revenue sources
Many companies generate revenues from a variety of sources (regular operations of the business and non-
operating sources) for example:
- When Chipotle sells burritos to consumers, it has earned/obtain revenue. When revenue is earned,
assets (usually la voce: Cash or Accounts Receivable) often increase.
- Sometimes if a customer pays for goods or services in advance, often with a gift card, a liability
account, (usually la voce: Unearned or Deferred Revenue) is created.
At this point, no revenue has been earned/obtained, because it is in the form of an obligation so we
can define it as a liability. There is simply a receipt of cash in exchange for a promise to provide a good
or service in the future. When the company provides (= fornisce) the promised goods or services to the
customer, then the revenue is recognized, and the liability is eliminated.

Revenue Recognition Criteria/conditions:

a) Revenue should be recognized only when it is EARNED: so, when exists credible evidence of an
arrangement (the seller’s price is fixed or determinable, the customer pays or promises to pay) or the
earnings process is complete or almost complete (the company has met its contractual obligations and
is entitled to the revenue, delivery has occurred or services have been rendered)
b) Revenues must be REALIZED or REALIZABLE: collectability is reasonably assured.
To sum up: when revenue is earned, assets, usually Cash or Accounts Receivable, often increase.
Sometimes if a customer pays for goods or services in advance, often with a gift card, a liability account,
usually Unearned (or Deferred) Revenue, is created. At this point, no revenue has been earned because
there is simply a receipt of cash in exchange for a promise to provide a good or service in the future and
when the company provides the promised goods or services to the customer, then the revenue is
recognized and the liability is eliminated.

 Cash is received before the goods or services are delivered. Until the goods or service is not delivered,
they record no revenue. Instead, it creates a liability account (Unearned Revenue) representing the
amount of good or service owed to the customers. Later, when customers redeem their gift cards and
the company deliver good or service, it earns and records the revenue while reducing the liability
account because it has satisfied its promise to deliver.

 Cash is received in the same period as the goods or services are delivered. This depend on the sector,
for example in the restaurant industry it is possible in a few minutes.

 Cash is received after the goods or services are delivered. When a business sells goods or services on
account, the revenue is earned when the goods or services are delivered, not when cash is received at
a later date.

 Example: When would revenues be recognized in these cases?

1. Case: sale of a gift card by a retailer = revenue is recognized at the time the card is used
2. Case: sale of a non-refundable airline ticket = revenue is recognized just after the flight occurred
3. Case: sale of a rug with a right to return = revenue is recognized at the time of the sale along with
an allowance account for the case of return
 4. Case: sale of a computer for $1,500 which includes a two-year service contract if repairs are
necessary (value of the contract is $ 240) = revenue for the computer is recognized at the time of
sale. Revenue for the service contract is recognized over the two year-period, probably monthly.
5. Case: sale of a gym membership for which you pay $3,600 upfront (the regular cost would have
been $4,500 if you didn’t pay upfront); you can use the gym anytime you want for 3 years and
cancel anytime during the 3 years and get the remaining money back. You decide to cancel after 4
months of usage = at the time of the transaction a “deferred revenue” or “unearned revenue”
account for $3600 is created. For the 4 months revenue is recognized monthly. Once the
membership is cancelled, the cash is returned, and the deferred revenue account is removed.

Potential Issues with Revenue Recognition

Companies are under pressure to show revenue that meets expectations of market participants, this can
lead to:
1. Improper timing of revenue recognition
2. Fictitious revenue
3. Channel stuffing (Example: Coca-Cola)

Some Recent Reporting Scandals

 SEC found that Fiat Chrysler inflated monthly sales results by paying automobile dealers to report fake
vehicle sales and maintaining a “cookie jar” of actual but unreported sales [INFLATED REVENUE]
 SEC found that Nissan and its former CEO falsified financial reports (e.g., omitted $140 million to be
paid to the CEO in retirement) [UNDESTATED EXPENSES]
 SEC is investigating iQIYI, a China-based video-streaming company, of committing fraud by
manufacturing orders and hiding expenses, which together added $1.9 billion to net income, 44% of
the reported amount [INFLATED REVENUES AND UNDESTAND EXPENSES]

A study discovers that around 20% of companies use accounting ruses to report earnings that don’t fully
reflect the companies underlying operations.

Earnings Management

v Do Managers Manage Earnings to Meet or Beat Earnings Estimates and Benchmarks?

 A study said that managers manage earnings to meet or beat analyst expectations
 Another study said that managers communicate with analysts to manage expectations
 Recent studies find that managers can manage earnings all the way up to the last moments before
an earnings announcement, following individual analyst forecasts and not just the consensus

v How do Managers Manage Earnings?

 Through managements’ discretion on accruals
 Where can management employ discretion?
o Deferring revenue when not necessary
o Capitalizing expenses instead of recognizing them on the income statement
 But managers can also use “real” earnings management (actions that affect real aspects of firms'
operations):
o Overproduction to report lower cost of goods
o Reducing prices to increase sale figures

v A real impact of Earnings Management

 Researchers have found links between earnings management to meet or beat expectations and
employee safety: They found one in 24 workers was hurt in outfits that either just beat or satisfied
earnings expectations versus one in 27 workers in outfits that comfortably beat or outright failed to
meet earnings expectations
These results, said the researchers, suggest that when managers are facing the possibility of narrowly
missing analyst forecasts, they might be increasing employee workloads, compelling them to move at a
faster pace, work longer hours and/or discount safety protocols that otherwise slow down work.”

Impact of Revenues on the Financial Statement

- On the Income Statement, revenues appear on the top line as “Revenues” or “Sales”.
- On the Balance Sheet, revenues impact Owners’ Equity. Specifically, Net Income affects Retained
Earnings, when Revenues increase so does Retained Earnings.
- On the Cash Flow Statement, revenues may affect Cash Flow from Operating Activities if cash is
received.

 Example: Recording revenue

The Ace Consulting Firm sold $10,000 worth of consulting services to Hi-Tech Corp.
Ace is earning revenue. How does it record this in each of the following cases?
A. If Hi-Tech Corp pays Ace cash at the time the services are performed, how is it recorded?
Cash will go up by $10,000, this is an asset on the Balance Sheet. Revenues will go up by $10,000,
this is an item on the Income Statement that will impact Retained Earnings on the Balance
Sheet
B. If Hi-Tech Corp pays Ace before the services are performed, how is it recorded?
Cash will go up by $10,000, this is an asset on the Balance Sheet. Unearned Revenues will go up
by $10,000, this is a liability on the Balance Sheet. Once services are performed the liability will
be cancelled and revenue will be recognized on the Income Statement.
C. If Hi-Tech Corp pays Ace after the services are performed, how is this recorded?
At the time service are performed Accounts Receivable will increase by $10,000, this is an asset
on the Balance Sheet. Revenues will increase by $10,000. At time of payment, cash will increase
by $10,000 and Accounts Receivable will decrease by the same amount.
EXPENSES
Expenses represent the amount of resources the entity used to earn revenues during the period. Expenses
reported in one accounting period actually may be paid for in another accounting period. Some expenses
require the payment of cash immediately, while others require payment at a later date. Some also may
require the use of another resource, such as an inventory item, which may have been paid for in a prior
period. Therefore, not all cash expenditures (outflows) are expenses, but expenses are necessary to
generate revenues.

Expense Recognition
Also called the matching principle: it requires that expenses be recorded in the same time period when
incurred in earning revenue.
Expenses generally fall into two categories:
1. Periodic
- Not tied to a particular revenue stream
- Paid after the service is rendered or the goods are received
2. Deferred (referred to as “Deferred Costs”, not “Deferred Expenses”)
- Associated with an identifiable revenue stream
- Paid before the identifiable revenue is received

 Cash is paid before the expense is incurred to generate revenue. Companies purchase many assets
that are used to generate revenues in future periods. Examples include buying insurance for future
coverage, paying rent for future use of space, and acquiring supplies and equipment for future use.
When revenues are generated in the future, the company records an expense for the portion of the
cost of the assets used—costs are matched with the benefits.
 Cash is paid in the same period as the expense is incurred to generate revenue. Expenses are
sometimes incurred and paid for in the period in which they arise. An expense is incurred and recorded
(Repairs Expense).

 Cash is paid after the cost is incurred to generate revenue. Although rent and supplies are typically
purchased before they are used, many costs are paid after goods or services have been received and
used. Examples include using electric and gas utilities in the current period that are not paid for until
the following period, using borrowed funds and incurring Interest Expense to be paid in the future, and
owing wages to employees who worked in the current period. Any amount that is then owed to
employees at the end of the current period is recorded as a liability called Wages Payable (an accrued
expense obligation).

Expense Sources
 Expenses can come from the main operations of the business (OPERATING EXPENSES):
o Cost of Goods Sold (COGS) = not really an expense per se; it is a cost
o Selling, General and Administrative Expenses (SG&A)
o Marketing Expenses (if separate from SG&A)
o Depreciation Expense
o Restructuring Expense
 Expenses can come from non-operating sources (NON-OPERATING EXPENSES)

Impact of Expenses on the Financial Statement

 On the Income Statement, expenses appear as COGS, Operating Expenses, or Non-operating Expenses
 On the Balance Sheet, expenses impact Owners’ Equity. Specifically, through Net Income which is
related to the Retained Earnings account. Every time an expense is recognized, Retained Earnings
decreases.
 On the Cash Flow Statement, expenses may affect Cash Flow from Operating Activities if cash is paid
out.

 Example: Recording expenses

The Ace Consulting Firm sold $10,000 worth of consulting service to Hi-Tech Corp.
Hi-Tech is incurring an expense. How does it record this in each of the following cases?
A. If Hi-Tech Corp pays Ace cash at the time the services are performed, how is it recorded?
An expense will be recognized of $10,00D, this will appear on the Income Statement and reduce
Net Income. Cash will go down by $10,000
B. If Hi-Tech Corp pays Ace before the services are performed, how is it recorded?
An asset "Prepaid Expenses" will be created on the Balance Sheet. Cash will go down by $10,000
 C. If Hi-Tech Corp pays Ace after the services are performed, how is this recorded?
An expense will be recognized of $10,000; this will appear on the Income Statement and reduce
Net Income. A liability named *Accrued Expenses Payable" will be created, once the expense is
paid it will be removed

NET INCOME (net earnings) (Net Income = total revenues – total expenses)
Net Income often called “the bottom line” represent the excess of total revenues over total expenses. If
total expenses exceed total revenues, a net loss is reported. Net income normally does not equal the net
cash generated by operations.
 Income tax expenses= it is the pre-tax income; it is income that we have before of subtracting tax
 Operating Income = represents a measure of the profit from central ongoing operations.
Operating income = net sales (operating revenues) – operating expenses (including cost of goods sold).

ACCRUAL ACCOUNTING AND THE INCOME STATEMENT

Accrual basis accounting: records revenues when earned and expenses when incurred, regardless of the
timing of cash receipts or payments.
Why do we use accrual accounting rather than cash accounting? Because it provides the best economic
picture of the company, it shows the relationship between Revenues and Net Income
 Example: Suppose company A sells $1,000,000 of goods to Company B and delivers them.
The goods cost Company A $900,000 (which it has paid). Company B will pay Company A within 3
weeks.
Cash accounting $ Accrual accounting $
Revenue 0 Revenue 1,000,000
Cost - 900,000 Cost - 900,000
Net Income = 900,000 Net Income = 100,000
Profit Margin: Not meaningful Profit Margin: 0.1
Net Income/Revenues Net Income/Revenues
What will happen?

The two basic accounting principles

The two basic accounting principles that determine when revenues and expenses are recorded under
accrual basis accounting are:
- the revenue recognition principle = revenues are recognized (1) when the company transfers promised
goods or services to customers (2) in the amount it expects to be entitled to receive.
- the expense recognition principle (also called the matching principle) = requires that expenses be
recorded in the same time period when incurred in earning revenue.

The Income Statement – Kroger (come la Conad in Italia)

v The top line in the income statement is Sales (also referred to as “Revenue”). This is the main source of
income from the continuing operations of the firm. Firms can present revenues from different activities
or just in one line (as seen by Kroger).
v Revenues are followed by the “Cost of Goods Sold” (COGS), these are the costs immediately associated
with the sales. These mainly include the cost of inventory but also include any other cost management
deems appropriate.
= The difference between the two is called the “Gross Profit”

“THE GROSS PROFIT” (Utile Lordo) SCRIVI TYUTTE LE FORMULE

Gross profit = is a measure of the firm's profitability from the sale of its products.
Gross profit is the total revenue less only those expenses directly related to the production of goods for
sale, called the cost of goods sold (COGS). COGS represents direct labor, direct materials or raw materials,
and a portion of manufacturing overhead that's tied to the production facility. COGS does not include
indirect expenses, such as the cost of the corporate office.
Below the Gross Profit the firm presents other operating items such as:
o Selling General and Administrative (SG&A) expenses – these can include wages and advertising costs
o Depreciation and amortization – associated with fixed assets.

Gross Profit = total revenues – total expenses (including cost of goods)

Gross Profit Sales−COGS

Gross Profit Margin (Gross Margin ratio) = o
Total revenue Sales

Since COGS represents the cost of acquiring inventory and manufacturing the products, gross profit
reflects the revenue left over to fund the business after accounting for the costs of production.
It doesn’t include debt expenses or taxes.

“THE OPERATING PROFIT”

Operating Profit = Subtracting these expenses from Gross Profit produces the “Operating Profit” which
represents the income to the firm from its continuing operations.
Derived from gross profit, operating profit reflects the residual income that remains after accounting for
all the costs of doing business. In addition to COGS, this includes fixed-cost expenses such as rent and
insurance, variable expenses, such as shipping and freight, payroll and utilities, as well
as amortization and depreciation of assets. All the expenses that are necessary to keep the business
running must be included.
“Operating Profit” is also referred to as “the line”; items “Below the Line” (under Operating Profit):
• Interest expense (or income)
• Gain (or loss) on investments
• Gain (or loss) on the sale of business

Operating Profit
Operating Profit Margin:
Sales
Ricorda: Operating profit c’è scritto gia, devo trovare l’Operating profit Margin io

“EARNINGS BEFORE TAX (EBT)”

Earnings before tax = Subtracting (or adding) these items to Operating Profit leads to Earnings Before Tax.

“NET INCOME”
Net Income = Subtracting the Tax Expense from EBT leads to Net Income. “Net Income” is also referred to
as “the bottom line”. It is different from the gross profit because in net income I subtract the taxes.

OTHER COMPREHENSIVE INCOME

Accounting rules and regulations require some gains and losses be presented apart from the income
statement. Some examples:
 Changes in revaluation surplus (IAS 16 and IAS 38)
 Actuarial gains and losses on defined benefit plans recognized in accordance with IAS 19
 Gains and losses arising from translating the financial statements of a foreign operation (IAS 21)
 Gains and losses on re-measuring available-for-sale financial assets (IAS 39)
 The effective portion of gains and losses on hedging instruments in a cash flow hedge (IAS 39).

REVIEW
1. What transactions do the following reflect? What was the transaction that preceded them (if any)?
a. Salaries Payable decreases by $75,000; Cash Decreases by $75,000
> Salary Expense increases by $75,000; Salaries Payable increases by $75,000
It describes the workers paid, workers worked and provided services which generated revenue for
the company, the income statement before this would be lower but they would have liabilities in
the balance sheet; salaries expenses increase by 75.000 and salaries payable increases by 75.000.
b. Cash increases by $35,000; Interest Receivable decreases by $35,000
> Interest Receivable increases by $35,000; Interest Revenue increases by $35,000
We are owed interest but they still haven’t paid us; interests receivable increases by 35.000 and
interest revenue increases by 35.000.
c. Utility Expense increases by $45,000; Utilities Payable increases by $45,000
> No preceding transaction
d. Unearned Revenue decreases by $50,000; Revenue increases by $50,000
> Cash increases by $50,000; Unearned Revenue increases by $50,000
The company gets the cash ut the good has not been delivered so it is a current liability; cash
increases by 50.000 and unearned revenue increases by 50.000.
e. Depreciation Expense increases by $10,000; Accumulated Depreciation increases by $ 10,000
> Purchase of fixed asset would have been recorded
Accrual accounting system allows o avoid recognizing the huge investments at once dividing the
expenses in the period of the assets; purchase of fixed asset would have been recorded
2. Why does accrual accounting require depreciation of plant and equipment?
Matching Principle

To sum up:
 If I had the revenues and I subtract only the COGS expenses I have the Gross Profit that measure
profitability from its production.
 If I had the revenues and I subtract COGS expenses, fixed and variable expenses, amortization and
deprecation of assets.
 At the end I have the Net income that is the operating income less the taxes.
TRANSACTION ANALYSIS RULES
All accounts can increase or decrease, although revenues and expenses tend to increase throughout a
period. For accounts on the left side of the accounting equation, the increase symbol + is written on the left
side of the T-account. For accounts on the right side of the accounting equation, the increase symbol + is
written on the right side of the T-account, except for expenses, which increase on the left side of the T-
account. That is because, as expenses increase, they have an opposite effect on net income, the Retained
Earnings account (which increases on the credit side), and thus Stockholders’ Equity.
Debits (dr) are written on the left of each T-account and credits (cr) are written on the right.
Every transaction affects at least two accounts.

When a revenue or expense is recorded, either an asset or a liability will be affected as well:
 Revenues increase stockholders’ equity through the account Retained Earnings and therefore have
credit balances (the positive side of Retained Earnings). Recording revenue requires either increasing
an asset (such as Accounts Receivable when selling goods on account to customers) or decreasing a
liability (such as Unearned Revenue that was recorded in the past when cash was received from
customers before being earned).

 Expenses decrease stockholders’ equity through Retained Earnings. As expenses increase, they have
the opposite effect on net income, which affects Retained Earnings. Therefore, they have debit
balances (opposite of the positive credit side in Retained Earnings). That is, to increase an expense, you
debit it, thereby decreasing net income and Retained Earnings. Recording an expense requires either
 decreasing an asset (such as Supplies when used) or increasing a liability (such as Wages Payable when
money is owed to employees).
 When revenues exceed expenses, the company reports net income, increasing Retained Earnings and
stockholders’ equity.
 When expenses exceed revenues, a net loss results that decreases Retained Earnings and thus
stockholders’ equity

ADJUSTMENTS
Managers are responsible for preparing financial statements that will be useful to investors, creditors, and others or
analyzing the past and predicting the future.
 Revenues are recorded when earned
 Expenses are recorded when incurred to generate revenue

 Assets are reported at amounts that represent the probable future benefits remaining at the end of
the period
 Liabilities are reported at amounts that represent the probable future sacrifices of assets or services
owed at the end of the period.
Because recording these and similar activities daily is often very costly, most companies wait until the end
of the period (annually, but monthly and quarterly as well) to make adjustments.
Adjusting entries are necessary at the end of the accounting period to measure income properly, correct
errors, and provide for adequate valuation of balance sheet accounts.

Type of Adjustments
1. Deferred Revenues: When a customer pays for goods or services before the company delivers them,
the company records the amount of cash received in a deferred (unearned) revenue account. This
unearned revenue is a liability representing the company’s promise to perform or deliver the goods or
services in the future. Recognition of (recording) the revenue is postponed (deferred) until the
company meets its obligation.
2. Accrued Revenues: Sometimes companies perform services or provide goods (that is, earn revenue)
before customers pay. Because the cash that is owed for these goods and services has not yet been
received and the customers have not yet been billed, the revenue that was earned may not have been
recorded. Revenues that have been earned but have not yet been recorded at the end of the
accounting period are called accrued revenues.
3. Deferred Expenses: Assets represent resources with probable future benefits to the company. Many
assets are used over time to generate revenues, including supplies, buildings, equipment, and prepaid
expenses for insurance, advertising, and rent. These assets are deferred expenses (that is, recording
the expenses for using these assets is deferred to the future). At the end of every period, an
adjustment must be made to record the amount of the asset that was used during the period.
4. Accrued Expenses: Numerous expenses are incurred in the current period without being paid until the
next period. Common examples include Wages Expense for the wages owed to employees who worked
during the period, Interest Expense incurred on debt owed during the period, and Utilities Expense for
the water, gas, and electricity used during the period. These accrued expenses accumulate (accrue)
 over time but are not recognized as expenses with the related liability until the end of the period
through an adjusting entry.

Ricorda:.Recording adjusting entries has no effect on the Cash account (almost every account, except Cash,
could require an adjustment)

Week 2 - 30 September 2022

DEBITING AND CREDITING CHE CENTRA? GIA MESSA QUESTA FOTO SOPRA

Journal Entries:
General format: Account being Debited XXXX
Account being Credited XXXX

Examples: of Journal Entries that involve Balance Sheet Accounts CHE CENTRA?
MEASURING AND REPORTING RECEIVABLES

Receivables may be classified in three common ways:

1. Account receivable or note receivable
 Accounts receivable (trade receivables/receivables) = is created by a credit sale on an open account
 Notes receivable = is a promise in writing ( a formal document) to pay (1)a specified amount of
money, called the principal, at a definite future date known as the maturity date and (2) a specified
amount of interest at one or more future dates. The interest is the amount charged for use of the
principal.
2. Trade receivable or nontrade receivable
 Trade receivable = is created in the normal course of business when a sale of merchandise or
services on credit occurs
 Nontrade receivable = arises from transactions other than the normal sale of merchandise or
services.
3. Current receivable or noncurrent receivable
 Current receivable = short-term
 Noncurrent receivable = long term

ACCOUNTS RECEIVABLE
Accounts Receivable are commitments of customers to pay arising from past sales.
These are basically sales on credit.
Granting credit to customers is costly to the seller for two reasons:
1. Credit risk (bad debt = debt that won’t be repaid)
2. Cost of capital (seller receives the cash only at some future date; money received today is worth more
than money received tomorrow/ time value of money).

Issues Regarding Accounts Receivable

How should Accounts Receivable be valued? How should the Bad Debt Expense be determined?
1. Direct write-off method
A receivable is written-off only after the account is determined to be uncollectible. What are some
potential problems with this?
2. Allowance method
 An estimate is made of the expected uncollectible accounts out of all the credit sales for a period. The
estimate is recorded as an expense in the period the credit sales are made.
There are two approaches that can be taken:
a) Aging method
b) Percentage of Sales

Two Allowance Methods

The difference is that:
1. Aging-of-Accounts – Focus is on the Balance Sheet
2. Percentage of Sales – Focus is on the Income Statement

Applying the Allowance Method:

Consider the following three stages in the process:
1. At the end of the initial year, establish an allowance by estimating future uncollectible accounts.
2. During the subsequent year, write off actual bad debts as uncollectible. Note that actual write-offs
may differ from the previous year’s estimate.
3. At the end of the subsequent year, once again estimate future uncollectible accounts and replenish the
allowance.

Comparison of the Aging-of-Accounts vs the Percentage-of-Sales Methods

 Aging-of-Accounts = results in a more accurate valuation of the Accounts Receivable on the Balance
Sheet Does not provide good matching with revenues in the income statement.
 Percentage-of-Sales Method = results in better matching of Revenues with the Bad Debt Expense
Directly compute the amount to be recorded as Bad Debt Expense on the income statement for the
period in the adjusting journal entry but it does not do a good job of valuing Accounts Receivable on
the Balance Sheet.
               
EXAMPLE 1:
A business is established at the beginning of Year 1.
 During Year 1:
Sales (all on credit) = $1,000,000
Accounts Receivable at the end of the year = $170,000
No account that has become uncollectible has been discovered.
 During Year 2:
Sales (all on credit) = $2,000,000
An account with a balance of $1,700 is deemed uncollectible.
Accounts Receivable at the end of the year = $170,000

Balance of accounts receivable at the end of Year 1 by age

Using the Aging Method
To reflect the expected uncollectible amount of $2,650 the company must recognize an expense on the
Income Statement (as part of SG&A).
To balance this expense out the company creates a Balance Sheet account called “Allowance for Doubtful
Accounts” of the same amount. This is a “Contra Asset” account (it is an asset account, but it reduces
assets).
Ricorda: The Bad Debt Expense is the cost of estimated future bad debts arising from Sales in the current
period.

Bad debt expense

Expense is the cost of estimated future bad

debts arising from Sales in the current
period. 
 It is the expense associated with estimated
uncollectible accounts receivable. 
The Bad Debt Expense is included in the
category “General and Administrative”
expenses on the income statement. 
It decreases net income and stockholders’ equity.
Accounts Receivable could not be credited in the journal entry because there is no way to know which
customers’ accounts receivable are involved. So the credit is made, instead, to a contra-asset account
called Allowance for Doubtful Accounts, this reduce the book value and the total asset.

During Year 2
An uncollectible account in the amount of $1,700 is discovered and deemed uncollectible
To write-off the bad debt: the company will reduce the allowance and reduce the Accounts Receivable
account (note that the AR that appears on the Balance Sheet is the amount NET of any allowance).
Write off impact on Balance Sheet:

At the end of Year 2

Expected value
The company needs to have $4,200 in the Allowance for Doubtful Accounts. of uncollectible
Currently, there is $950 in the Allowance [$2,500 – 1,700 (write-off) = 950] accounts
There needs to be an additional $3,250 in the Allowance to bring the balance up to $4,200
The $3,250 “replenishes” the Allowance account and is recognized as an expense on the Income
Statement.

Using the Percentage-of-Sales Method

The Bad Debt Expense is computed each year as a pre-determined percentage multiplied by the Credit
sales for the year

Back to the Example

Year 1:
Recall that for Year 1, Credit Sales were $1,000,000
Suppose that the estimated percentage of bad debts is 0.25%
The estimated Bad Debt Expense for the year is: 2,500 (1,000,000 X 0.25%)
The company will create the Allowance in the same way as before, recognizing a bad debt expense for the
amount. The company will treat the write-off (1,700) in the same way.

Year 2:
Recall that for Year 2 Credit Sales were $2,000,000.
The estimated Bad Debt Expense for the year is: 5,000 (2,000,000 X 0.25%)
What will the company do?
Recognize a bad debt expense of 5,000, increasing the Allowance by the same amount
What is the balance of the Allowance account at the end of the year?

EXAMPLE 2:
Allowance for credit losses
Trade accounts receivable
arise from the sale of
products on trade credit
terms. On a quarterly basis,
we review all significant
accounts as to their past due
balances, as well as
collectability of the
outstanding trade accounts
receivable for possible write off. It is our policy to write off the accounts receivable against the allowance
account when we deem the receivable to be uncollectible. Additionally, we review orders from dealers that
are significantly past due, and we ship product only when our ability to collect payment from our customer
for the new order is probable.
Our allowances for credit losses reflect our best estimate of losses inherent in the trade accounts
receivable
balance. We determine the allowance based on known troubled accounts, weighing probabilities of future
conditions and expected outcomes, and other currently available evidence
Amount not collect at the end: beginning balance+bad debt expense (charged/(credited) to costs and
expensens)-Write off (deduction)
 How much account receivables the company doesn’t collect? Schedule II valuation and qualifying
account (3406). A/R: BB+Sales on Account(acquisitions)-Collection on Account(Charged to cost and
expense)-Write offs (deduction)=EB
 Bad debt  = (Charged/Credited) to Costs and Expenses – Estimation of what won’t be collected
 Write off = Deductions (no impact) – I’m sure I’m not collecting
 Ending balance is going to be the beginning balance of next year: 7541  = 2180 (beginning of balance) +
13263 (bad debt) -7902 (write off)
 Allowance for doubtful account: beginning allowance+bad debt expense=ending allowance
ACCOUNTS RECEIVABLES AND RATIOS
We want to be able to compare the company to itself over the years and to other companies based on
their efficiency in collecting receivables and managing their credit sales in general.
Helpful Ratios and Analyses:
1. Accounts Receivable as a % of Sales
2. Allowance for Doubtful Accounts / Accounts Receivable
3. Bad Debt Expense as a % of Sales
4. Compare the sum of write-offs with the sum of the Bad Debt Expense for two-three years (the
information for this is provided as part of the footnotes to the financial statements)
5. Determine how much cash was actually collected from customers during the year
6. Accounts Receivable Turnover Ratio, that allows us to see how quickly the company collects its credit
sales (or how efficient they are in doing so)

a) Receivable turnover ratio: it reflects how many times average trade receivables were recorded and
collected during the period.
Total revenues( ¿ net sales)
Receivable turnover ratio= = times receivable collected
Avarage account receivable
Ricorda:

v Average account receivable =

Beginning net trade account receivable+ending net trade accounts receivable
2

v Beginning or ending net trade account è la stessa cosa di account receivable gross, dunque
entrambi sono uguali a : A/R + net of allowance.
AR
Beginning; ending net account; account receivable gross ¿
net of allowance

 If we have net of allowance we have to summarize it to A/R

 If we have allowance we have to subtract it to A/R
b) Average days sales in receivables: it indicates the average time it takes a customer to pay its
account.

365
AR turnover in days: = Days to Collect Receivables of Days Sales
receivable turnover ratio
Outstanding (DSO)

If we know the AR turnover in days from the previous year, we can subtract the different AR
turnover during the years and if the result is negative, it seems that the company is getting worse in
collecting receivable.

1. Domanda: What % A/R does management not expect to be able to collect in 2020?

Net allowance 1211

= = 0,0514 -> 5.14%
( AR +net allowance) (22340+1211)
 2. Domanda: On average, how long did it takes for Basset to collects its receivables during 2020?
Remember that credit sales are 30% of Total revenues $385863

Credit sales: 30% of total revenues $385863 = 0.3 * 385863 = 115758

beginning net trade AR+ ending net trade AR

Average account receivable: =
2
(21378 + 815) + (22340 + 1211) / 2 = 22872

Net sales (¿ Credit sales) 115758

Receivable turnover ratio: = = 5.06
Avarage account receivable 22872

365
AR turnover in days: = 365/ 5.06 = 72.1 days
receivable turnover ratio

AR turnover in days over the year: 72.1 days (2020) - 63 days (2019) - 54 days (2018) = - 45
So the company is getting worse in collecting receivable.

EFFECT ON STATEMENT OF CASH FLOWS 

When there is a net decrease in accounts receivable cash collected from customer is more than revenue,
and this decrease is added in computing cash flows.
When there is a net increase in account receivable cash collected from customers is less than revenue, and
this increase is subtracted in computing cash flows.
 I can compare bad debt and write off to see if evaluate predictions in schedule II about the ending balance
are true.
If bad debt expenses are higher than write offs

Cash and cash equivalents 

IAS 7 – Definition of Cash and Cash Equivalents
 Cash is defined as cash on hand and any deposit with banks (think of your bank account)
 Cash Equivalents is defined as short-term, highly liquid investments that are readily convertible into
known amounts of cash
o Subject to low risk (i.e., low chances of large changes in value over short periods of time)
o Held to meet short term obligations of the firm
o Maturity of instruments is three months or less
 The change in the cash position of the firm is explained by the Cash Flow Statement (we will get to it
later in the course).
 Restricted Cash
- These are sums of cash reserved for a specific purpose, usually specified by a contract.
- Restricted Cash is reported separately on the Balance Sheet and the Cash Flow Statement.

Week 3 - 3 October 2022

INVENTORY
Inventory definition = is tangible property that is (1) held for sale in the normal course of business or (2)
used to produce goods or services for sale. Inventory is reported on the balance sheet as a current asset
because it normally is used or converted into cash within one year or the next operating cycle.
The types of inventory normally held depend on the characteristics of the business:

v Merchandisers business (wholesale or retail businesses) hold Merchandise inventory = goods (or
merchandise) held for resale in the normal course of business. The goods usually are acquired in a
finished condition and are ready for sale without further processing.
Example: For Harley-Davidson, merchandise inventory includes the Motorclothes line and the parts and
accessories it purchases for sale to its independent dealers.
v Manufacturing business hold three type of inventory:
o Raw materials inventory: Items acquired for processing into finished goods. These items are
included in raw materials inventory until they are used, at which point they become part of
work in process inventory.
o Work in process inventory: Goods in the process of being manufactured but not yet complete.
When completed, work in process inventory becomes finished goods inventory.
o Finished goods inventory: Manufactured goods that are complete and ready for sale.

Issues regarding inventory:

1. What costs are included in inventory?
2. What information is provided about inventory in the financial statements?
3. LIFO and FIFO issues
4. How do you evaluate inventory management?
Required Disclosures on Inventory
v Companies are required to disclose:
a) the inventory method(s) being used and
b) the balance of the inventory by stage (i.e., raw materials, work-in-process, finished goods).
v Companies that use LIFO must also disclose:
a) the replacement cost of the inventory (this is approximately equal to the FIFO value) and
b) the difference between the LIFO value of the inventory and the inventory’s replacement cost. This
is known a the “LIFO Reserve.”

Example: LAZBOY

Inventories are stated at the

lower of cost or market. Cost is
determined using the last-in,
first-out ("LIFO") basis for
approximately 60% and 61% of
our inventories at April 30,
2022, and April 24, 2021,
respectively. Cost is
determined for all other
inventories on a first-in, first-
out ("FIFO") basis. The majority
of our La-Z-Boy Wholesale
segment inventory uses the
LIFO method of accounting,
while the FIFO method is
used primarily in our Retail
segment and Joybird
business.
Purchase inventory:
Inventory XXXX (+A)
Cash or A/P XXXX (-A/+L)

Sell Inventory:
Cost of Goods Sold YYYY (+Ex, -NI)
Inventory YYYY (-A)

Inventory: For our upholstery business within our Wholesale segment, we maintain raw materials and
work-in- process inventory at our manufacturing locations. Finished goods inventory is maintained at our
nine regional distribution centers as well as our manufacturing locations. Our regional distribution centers
allow us to streamline the warehousing and distribution processes for our La-Z-Boy Furniture Galleries®
store network, including both company-owned stores and independently-owned stores. Our regional
distribution centers also allow us to reduce the number of individual warehouses needed to supply our
retail outlets and help us reduce inventory levels at our manufacturing and retail locations.
Costs included in Inventory
What cost are included in inventory? Initial costs
What about fixed costs? Are they incorporated in the inventory value?
 Example: In a month, a commercial tractor manufacturer had the following costs (all $ in 000):
- Total fixed costs $3,600
- The selling price per tractor is $110.
- Variable costs: $50/unit

Let’s examine three scenarios:

1. Sales = Production
2. Sales < Production
3. Sales << Production
 Inventory and accounts payable from balance sheet and COGS from income statement. How to
understand how many units the company purchases. Beginning inventory (226,137) + purchases (x) –
COGS (1,440,042) = Ending Inventory (303,191), Purchase = 1,517,096 
 To see how much cash the company used for the purchase  Beginning accounts payable (94,152) +
purchases (1,517,096) = Cash (y) and Ending accounts payable (104,025), Cash = 1,507,223

Cost of Goods Sold (COGS)

Cost of goods sold (CGS) expense is directly related to sales revenue. Sales revenue during an accounting
period is the number of units sold multiplied by the sales price. Cost of goods sold is the same number of
units multiplied by their unit costs.
A company starts each accounting period with a stock of inventory called beginning inventory (BI). During
the accounting period, new purchases (P) are added to inventory. The sum of the two amounts is the
goods available for sale during that period. What remains unsold at the end of the period becomes ending
inventory (EI) on the balance sheet. The portion of goods available for sale that is sold becomes cost of
goods sold on the income statement. The equation is BI + P − EI = CGS.
LIFO AND FIFO
There are 2 inventory costing methods for determining cost of good sold. THE inventory costing methods
are alternative ways to assign the total dollar amount of goods available for sale between (1) ending
inventory and (2) cost of goods sold.
Lifo and Fifo assume that the inventory costs follow a certain flow.

A. FIFO
The first-in, first-out method, frequently called FIFO, assumes that the earliest goods purchased (the
first ones in) are the first goods sold, and the last goods purchased are left in ending inventory. This
means that each purchase is deposited from the top in sequence (i nuovi acquisti si trovano in cima).
Each good sold is then removed from the bottom in sequence (dal fondo vengono rimossi i primi beni
acquistati). THE FIRST IN IS FIRST OUT. The goods that are removed become cost of goods sold (CGS).
The remaining units become ending inventory. FIFO allocates the oldest unit costs to cost of goods sold
and the newest unit costs to ending inventory.

B. LIFO
The last-in, first-out method, often called LIFO, assumes that the most recently purchased goods (the
last ones in) are sold first and the oldest units are left in ending inventory. This means that each
purchase is deposited from the top in sequence (i nuovi acquisti si trovano in cima). But unlike FIFO,
each good is removed from the top in sequence (dalla cima vengono rimossi gli ultimi beni acquistati).
The goods that are removed become cost of goods sold (CGS). The remaining units become ending
inventory. LIFO allocates the newest unit costs to cost of goods sold and the oldest unit costs to ending
inventory.

Increase or Decrease:
 An increase in the LIFO Reserve during the period means that the reported COGS is greater than it
would have been had FIFO been used. (if LIFO reserve increase, the COGS is greater than in FIFO
 A decrease in the LIFO Reserve during the period means that the reported COGS is lower than it would
have been had FIFO been used. The decrease suggests that during the period, inventory costs were
declining, inventories were reduced (liquidated) or both.(if LIFO reserve decrease, the COGS is lower
than in FIFO)

 Example:

For LAZYBOY we can notice that the LUFO Reserve (referred to as Excess of FIFO over LIFO) increase
form Apr.24,2021 to Apr. 30,2019.

Advantages and Disadvantages of LIFO vs. FIFO

1. Which method is linked to the physical flow of goods?
2. Which method provides better matching of revenues and costs on the Income Statement? In the case
of increasing costs is FIFO, and in the case of decreasing costs is LIFO.
3. Which method provides better valuation of inventory on the Balance Sheet? In the case of increasing
costs is FIFO, and in the case of decreasing costs is LIFO.
4. Which method results in lower taxes? In the case of increasing costs is LIFO, and in the case of
decreasing costs is FIFO.

Anyway, the choice of methods is normally made to minimize taxes, this means that we use the method
that result in lower taxes.
Explanation:
 For inventory with increasing costs, LIFO is used on the tax return because it normally results in lower
income taxes. When unit costs are rising, LIFO produces lower net income and a lower inventory
valuation than FIFO.
 For inventory with decreasing costs, FIFO is most often used for both the tax return and financial
statements. When unit costs are declining, LIFO produces higher net income and higher inventory
valuation than FIFO.

International Perspective
LIFO and International Comparisons
While U.S. GAAP allows companies to choose between FIFO and LIFO, International Financial Reporting
Standards (IFRS) currently prohibit the use of LIFO.
U.S. GAAP also allows different inventory accounting methods to be used for different types of inventory
items and even for the same item in different locations.
 IFRS requires that the same method be used for all inventory items that have a similar nature and use.
These differences can create comparability problems when one attempts to compare companies across
international borders.

LOWER OF COST OR MARKET – Valuing Inventory on an Ongoing Basis

 Example: GAP has 100,000 high quality sweatshirts in stock that cost $18 each. When the sweatshirts
were purchased, the intention was to sell these sweatshirts at $30 each. The sweatshirts were not a
best seller. In fact, consumers would only buy them if they were marked down by 60% to $12 per shirt.
Further, $3,000 in transportation costs would be incurred to move these shirts from retail stores to
factory outlets.
How does the LCM rule apply?
Starting from the concept that inventories should be measured initially at their purchase cost in
conformity with the cost principle, if value of inventory falls below original carrying cost: inventories
must be reported at the lower of cost or market. This method serves to recognize a loss when net
realizable value drops below cost.
“Market” = “net realizable value” (= estimated selling price of the inventory less any costs of
completion, disposal, transportation, etc).
Compare carrying value with net realizable value
Carrying cost of the inventory = $1,800,000 [100,000 X 18]
Net realizable value = $1,197,000 [(100,000 X 12) – 3,000]
Difference = $603,000
Under lower of cost or net realizable value, companies recognize a “holding” loss (perdita di magazzino) in
the period in which the net realizable value of an item drops (si riduce), rather than in the period the item
is sold. When the NRV of a certain number of goods is lower than their cost per item we will have this
effects on BS: the cost of sold is a debt (debito perchè mi costano di più di quanto posso realizzare) that
increase equity but decrease stockholders’ equity (+E,-SE) and instead of the fact that some goods are sold
we have a lower asset (-A) because inventory is reduced and a credit that come from the sell of the goods.
The effect on the IS is a reduction of the income because there is an increase in cost (+C, -NI).
Is there a “higher of cost or market” (HCM) rule?
Companies are required to report the fall in inventory. What about inventory increases?
 Suppose that the cost of the GAP sweatshirts did not fall. In fact, the new cost of sweatshirts (if GAP
decided to replenish the inventory) is $20 each. Further, because customers really like the sweatshirts,
GAP decided to increase the sales price of the 100,000 sweatshirts in stock to $32 each.
How would the financial statements reflect this?
 BS: cost of goods sold -E;+SE, Inventory unaffected
 IS: +R,+NI

INVENTORY: EFFECT ON STATEMENT OF CASH FLOW

 When a net decrease in inventory for the period occurs, sales are greater than purchases; thus, the
decrease must be added in computing cash flows from operations.
 When a net increase in inventory for the period occurs, sales are less than purchases; thus, the increase
must be subtracted in computing cash flows from operations.
 When a net decrease in accounts payable for the period occurs, payments to suppliers are greater than
new purchases on account; the decrease must be subtracted in computing cash flows from operations.
 When a net increase in accounts payable for the period occurs, payments to suppliers are less than
new purchases on account; thus, the increase must be added in computing cash flows from operations.

What Happens if Inventory Becomes Obsolete or Damaged or Unsaleable?

Inventory is written down (svalutate) under the LCM rule (this method recognize a loss if net realizable
value is lower than cost of goods). Inventory is also written down if there is “shrinkage”, damage, etc.
 If the amount of the loss in value is relatively minor, then the charge is to COGS.
 If the loss is material, then it may be reported in a separate account: Inventory Write-Down or a similar
name.
Week 4 – 14 October 2022

THE CASH CONVERSION CYCLE

The Cash Conversion Cycle is a way of determining how long cash is tied up in the operations (or working
capital) of the firm (un modo per calcolare quanto tempo la liquidità è vincolata alle operazioni
dell’azienda).
Cash Can Be “Tied Up” in A/R and Inventory.
 Cash Conversion Cycle (CCC) = Days Until Cash – A/P Turnover in days
 Days Until Cash = A/R Turnover in Days + Inventory Turnover in Days

Cash Conversion Cycle (CCC) = A/R Turnover in Days + Inventory Turnover in Days – A/P Turnover in
days

Calculating the Components of the Cash Conversion Cycle

A. Average Payment Period, also referred to as Days of Payable Outstanding or Accounts Payable
Turnover in Days
It is the average payment period in days to suppliers. It measure how long it takes the company to pay
its suppliers.
Cost of Goods Sold
First calculate: Accounts Payable Turnover =
Avarage Account Payable

 COGS is obtained from the Income Statement

 Avg. Accounts Payable is obtained from the Balance Sheet

365
To get the measure in days (DSO): A/P Turnover in Days =
AP Turnover
B. Average Collection Period, also referred to as Days of Sales Outstanding (DSO) or or Accounts
Receivable Turnover in Days – is the average collection period in days of sales
Sales
First calculate: Accounts Receivable Turnover =
Avg . Accounts Receivable

 Avg. Accounts Receivable is obtained from the Balance Sheet

 Sales is obtained from the Income Statement

365
To get the measure in days (DSO): A/R Turnover in Days =
Accounts receivables Turnover

C. Inventory Turnover, also referred to as Days in Inventory – is defined as the ratio of cost of goods
sold to average inventory
A higher ratio indicates that inventory moves more quickly through the production process to the
ultimate customer, reducing storage and obsolescence costs. Because less money is tied up in
inventory, the excess can be invested to earn interest income or reduce borrowing, which reduces
interest expense. Interpretation of Inventory Turnover: it provides an estimate of the number of times
inventory is sold throughout the year. Example: a turnover of 6 means the company sold its entire
inventory 6 times during the year, or that an item remained in the inventory of the company, on
average, 2 months.
Cost of Goods Sold
First calculate: Inventory Turnover Ratio =
Avarage Inventory

 COGS is obtained from the Income Statement

 Avg. Inventory is obtained from the Balance Sheet

365
To get the measure in days (DSO): Inventory Turnover Ratio in Days =
Inventory Turnover ratio
Scheme that shows how CCC works:

Evaluating Inventory Management – practical

example (Bassett Furniture)

2020
163,567/[(54,886+66,302)/2] = 2.95X
365 / 2.95X = 123.4 days

2019
179,244/[(66,302 + 54,476)/2] = 2.75X
365 / 2.75X = 132.7 days

What does this measure tell us?

This measure tell us how many days an items remained in the inventory of the company, this is the average
time that company takes to deliver inventory to customers. In 2020 it’s 123.4 days and in 2019 it’s 132.7
days.

EARNINGS PER SHARE (EPS)

EPS is a measure that emphasizes the amount of earnings attributable to a single share of outstanding
common stock. Because the number of outstanding shares of common stock changes over time, and is
different across firms, using EPS rather than just net income allows analysts and investors to make
“profitability per share” comparisons across time and across firms.
EPS is reported on the Income Statements.

Earnings Per Share (EPS)= (Net Income – Preferred dividend) / Wtd. Avg. number of common shares
outstanding
How to calculate the EPS from the financial statements?

To calculate EPS I have to look:

v For nominator: to the Income Statement at Net Income. I have to take the Net Income.
v For the denominator: to the Balance Sheet at Stockholders’ Equity. I have to take the average number
of common shares outstanding that are the sum between the two values of issues and outstanding
December 31 2021 and December 31 2020, then I divided by 2.

Why is EPS so important?

 Example:
Currently, Apple is trading at stock price is $138.98. Should I buy (or buy more) of this stock or sell it?
Apple reported EPS of $6.05 for the year ended Dec. 31, 2021
(EPS = Net Income / Wtd. Avg. No. of Common Shares Outstanding)

If I want to understand to buy or not using EPS as a valuation tool: Projected EPS * Price/EPS for the
industry = Projected Price

Average analysts’ estimate for Apple’s EPS for 2022 is $6.1 for the year
Projecting the stock price: $6.11 X 30 = $183
This kind of valuation depends on 2 estimates: the projected EPS and the industry P/E ratio

Would you buy? Yes, because in the current year (2021) the price is lower (in relation with the
projecting stock price that will be higher).

Week 5 – 17 October 2022

LONG-TERM ASSETS
Long term or lived assets are tangible and intangible resources owned by a business and used in its
operations over several years.
v Tangible Assets or PPE: assets that have physical substance used in operations.
- Land, buildings, fixtures, and equipment also called Property, Plant and Equipment (PPE) or fixed
assets.
- Natural resources
v Intangible Assets: assets that have special rights but not physical substance.
Recording Initial Costs
“Cost” includes all expenditures needed to make the asset operational. These costs are:
 Invoice price
 Custom dues
 Freight-in charges (transportation cost)
 Insurance on route
 Installation costs to acquire and prepare the asset for use
 Sales taxes
 Legal fees
 Other necessary and anticipated costs
These expenditures are capitalized (recorded as part of the total cost of the asset), not recorded as
expenses in the current period. However, any interest charges associated with the purchase are recorded
as expenses as incurred.

Operating Long-Term Assets

May be tangible or intangible assets.
Tangible operating assets are commonly referred to as Property, Plant and Equipment (PPE).
Long-term assets that are not used in operations are classified as “investments”.
Operating assets are generally carried on the books at cost, less depreciation or amortization.
Special valuation issues:
a) Lump sum purchases (bundle)
b) Interest on self-constructed assets
c) Exchange on non-monetary assets (trade-in)

A. Lump-Sum Acquisition
Often, the business acquires a “portfolio” of assets, e.g., a factory that includes land, structures,
fixtures, and machinery, in a package deal for a lump sum.
In such cases it is necessary to allocate the purchase price of the “bundle” to its individual components.
The allocation is based on the relative fair values of the components.
 Example: Allocating Acquisition Cost of a Bundle of Assets
A national steel company paid $8 million to acquire a steel production facility from a local company
in Pittsburgh.The purchased property includes land, a factory and machinery.
The fair value of the assets acquired was appraised as follows:
- Land $4.0 mil.
- Buildings 3.5 mil.
- Equipment 2.5 mil.
= Total Fair Value 10.0 mil.

How should the acquisition

cost be allocated?

Valuation of an Asset Acquired in a Trade-in

Chobani Yogurt trades in its old industrial blender, used in the production of its well-known yogurt, for a
new blender.
The old blender has an original cost of $220,000 and accumulated depreciation of $170,000.
The list price of the new blender is $370,000 but most buyers, including Chobani, negotiate the price down.
The dealer agrees to a trade-in, where Chobani surrenders the old blender and pays only $310,000. The
fair value of the old blender in the market is $35,000.

1. What would be the cost of the new blender on Chobani’s balance sheet?
 The cost of the new blender should be the economic sacrifice made by Chobani in acquiring the new
blender.
In this case, the economic sacrifice is the cash payment plus the fair value of the old blender: $310,000
+ $35,000 = $345,000

2. What is the impact of the transaction on the financial statements?

Depreciation
Except for land, which is considered to have an unlimited life, a long-lived asset with a limited useful life
represents the prepaid cost of a bundle of future services or benefits. The expense recognition (matching)
principle requires that a portion of an asset’s cost be allocated as an expense in the same period that
revenues are generated by its use. The term that identify this matching between the cost of using buildings
and equipment with the revenues generated is “Depreciation”.
Depreciation: the process of allocating the cost of buildings and equipment (but not land) over their
productive lives using a systematic and rational method. This is a process of cost allocation.

What happened on the financial statement?

 The amount of depreciation recorded during each period is reported on the income statement as
Depreciation Expense. (+E,-SE)
 The amount of depreciation expense accumulated since the acquisition date is reported on the balance
sheet as a contra-account, Accumulated Depreciation, and deducted from the related asset’s cost.
(+XA,-A)
 If we subtract accumulated depreciation from the related asset’s cost the amount is called Net book
value and it is reported on the balance sheet.

To calculate the depreciation of a long-term asset, we need to know several things about the asset:
o Cost (C): Also referred to as the “carrying value” or the “book value”
o Residual value (R): The amount expected to be received from the disposition of the asset, net of any
disposal cost, at the end of the asset’s life.
o Useful life (N): The estimated useful life of the asset in the service of the company.
The useful life is finite because of:
- Physical wear and tear
- Technological obsolescence
Both the Residual value and the Useful life are ESTIMATES!

Different methods of depreciation

1. STRAIGHT-LINE METHOD
Method that allocates the depreciable cost of an asset in equal periodic amounts over its useful life.
Straight-line formula: Depreciation Expense = (Cost-Residual Value) / (Number of years)

Depreciable cost Straight-Line rate

 Advantages:
- Simple and understandable
- Commonly used
 Disadvantages:
- Assumes that benefits are evenly distributed
- Ignores the extent of the asset’s utilization

In this method:
 Depreciation expense is a constant amount each year
 Accumulated depreciation increases by an equal amount each year
 Net book value decreases by the same amount each year until it equals the estimated residual
value. this is the reason why it is called straight-line method

 Example of depreciation: straight-line method

C = $34,000; N= 5 years; R= $4,000

Straight line depreciation: Amount to be depreciated -
Number of Years = (C-R)/N = Annual Depreciation
Amount to be depreciated= C – R = $34,000 - $4,000 =
$30,000
Annual Depreciation = $30,000/5 = $6,000
 But if asset is sold at the beginning of Year 4 for 19,400$ in cash

What is the journal entry?

 Cash: 19,400 (BS, A+) it is given by the text
+
 Accumulated Depreciation: 18,000 (BS, A+) it is the sum between the 3 value of the straight-line
depreciation
=37400
-
 PPE: 34,000 (BS, A-) it is the value of the sold of PPE (tangible assets), it is given at year one of beg.
Balance
=3,400 (IS, NI+) Gain on sale of PPE. It is the difference between the value of PPE and the sum of
cash and accum. dep. is the gain on sale of PPE, it is what I obtained from the sold of PPE.

2. ACTIVITY METHOD (UNITS-OF-PRODUCTION OR OUTPUT METHOD)

Method that allocates the depreciable cost of an asset over its useful life based on the relationship of
its periodic output to its total estimated output.
Activity method formula: Depreciation Expense = (Cost – Residual) / Number of Units

 Advantages
- Takes into account the extent of the asset's utilization
 Disadvantages
 - Ignores passage of time (obsolescence) as cause for depreciation
- Impossible or costly to implement for many assets

3. DOUBLE DECLINING-BALANCE METHOD OR DECREASING-CHARGE (ACCELERATED) DEPRECIATION

METHOD
Method that allocates the net book value (cost minus accumulated depreciation) of an asset over its
useful life based on a multiple of the straight-line rate, thus assigning more depreciation to early years
and less depreciation to later years of an asset’s life.
Decreasing-charge method formula: Depreciation Expense = (Constant % X Beginning of Balance of
Asset)

Where the constant percentage is double, the depreciation rate per period implied by straight-line
depreciation (this is the source of the term “double”)
The depreciation rate per period implied by straight line depreciation is 1/N. Double that and you get
2/N.
Applying the double declining rate of 2/N (instead of the exact rate, which can be derived algebraically)
would not bring the net balance of the asset at the end of its life down to its exact residual value.
Therefore, we apply the method to the early years of the asset and then use straight-line depreciation
to depreciate the remaining balance of the asset.

o Example of depreciation: Double-Declining Balance Method

C = $34,000; N= 5 years; R= $4,000

Constant percentage = (2 X 1/5) = 2/5 = 0.4 = 40%
Then I multiplied this value for every beg. Balance
and so I find the Double Declining Depreciation

Comparison of Depreciation Expense Using Straight-Line and Double-Declining Balance Methods

If I compare the two methods of depreciation, I obtained the

same total.

What can we learn from Depreciation Disclosures?

We can learn Age of the Assets.

Relative to their full useful life: Fraction of Full Life = Accumulated Depreciation / Gross PPE
In terms of years: Age = Accumulated Depreciation / Depreciation Expense

 Example:
 % of Life Utilized:
Accum. Dep. / Gross PPE

2021: 32,342 / 59,274 =

54.56%

Age in years:
Accum. Dep. / Dep. Exp.

2021: 32,342 / 2,986 =

10.83 ~ 11 years

CHANGE IN ESTIMATES
There are three estimates related to depreciation:
 Pattern of benefits over time (i.e., the depreciation schedule – straight line, accelerated, etc.)
 Useful life
 Residual value
These estimates are approximations. It is very unlikely that the actual result will perfectly match the
estimates.
When we are aware that the original estimate is wrong, we have to correct it. Why?
Because if we not correct the allocation cost will be wrong (depreciation will be wrong).

How to Correct the Estimate

Acceptable Ways:
1) Spread the underpreciated balance ($10,000 - $6,000), over the remaining life (2 years)
That is, a depreciation expense of $2,000 in each of the two remaining years (Years 7 and 8).
2) Add to the balance of accumulated depreciation a one-time adjustment of $1,500 to bring it to the
correct balance of $2,500. This would appear on the Income Statement in Year 7.

Unacceptable Ways:
It is unacceptable to correct years 1-6 retroactively (by restating the results reported for those years).
It is unacceptable not to correct immediately.

 Example of a Change in Estimate:

Change in estimate reported in Intel’s 2016 10-K
During our 2015 annual assessment of the useful lives of our property, plant and equipment, we
determined that the estimated useful lives of machinery and equipment in our wafer fabrication
facilities should be increased from 4 to 5 years based on the lengthening of the process technology
cadence resulting in longer node transitions on both 14 nanometer (nm) and 10 nm products.
This change in estimate was applied prospectively, effective at the beginning of 2016.
For 2016, this change increased our operating income by approximately $1.3 billion, our net income by
approximately $950 million, and out diluted earnings per share by approximately $0.19.

REPAIRS, MAINTENANCE, IMPROVEMENTS AND OVERHAULS

t Repairs and Maintenance: cost of repairs and periodic maintenance is expensed as incurred.
Expenditures that maintain the productive capacity of an asset during the current accounting period
only and are recorded as expenses.
- Maintenance and repairs expense (+E,-SE)
- Cash (-A)
t Improvements and Overhaul: cost of improvements and overhauls that either increase the asset’s
productivity or extend its useful life beyond the level originally anticipated is capitalized. It is recorded
as an increases in asset accounts not as expenses.
The capitalization takes the form of adding the cost of the improvement or overhaul to the cost of the
asset.
- Equipment (+A)
- Cash (-A)

 Example: Overhaul of a Machine

C = 10,000, R = $1,000, N = 10
Straight-line depreciation
At the beginning of year 6 the company overhauls the machine at a cost of $4,000
It is estimated that the overhaul will extend the useful life of the asset by 2 years (from 10 to 12).
It will not change the residual value.

Journal entry:
o Machine (PPE) 4,000 (BS, A+)
o Cash 4,000 (BS, A-)

Depreciation Expense in Year 6:

Book value at the beginning of Year 6:
o Cost – Accum. Dep. = 14,000 – (900 X 5) = 9,500 (14,000 is 10,000+4,000, cost+overhauls; 900 is the
accum dep for the 5 previous years)
o Depreciable Amount = 9,500 – 1,000 = 8,500 (1,000 is the residual value)
o Dep. Expense = 8,500 / 7 = 1,214

IMPAIRMENT
LCM (lower cost market) is not applied to long-lived assets. The reason is that long-lived assets are not held
for the purpose of sale (like inventory) but for the purpose of being used in the operations.
However, if there is a permanent impairment in the ability of the asset to produce future benefits, the
asset should be written down to reflect this impairment. An impairment exists whenever the expected
benefits from the asset fall below the net book value of the asset.
Test for Asset Impairment:
To test an asset for recoverability:
1) Test for impairment: impairment occurs when events or changed circumstances cause the estimated
future cash flows (future benefits) of these assets to fall below their book value.
Compare its estimated future undiscounted cash flows with its carrying value (net book value).
The asset is considered recoverable when future cash flows exceed the carrying amount, and in this
case no impairment is recognized.
The asset is not recoverable when future cash flows are less than the carrying amount.
 If net book value > Estimated future cash flows, then the asset is impaired

2) If the asset is impaired, the company recognizes an impairment loss for the amount the carrying value
exceeds fair value.
 Impairment Loss = Net Book Value − Fair Value

The estimated cash flows used to test for recoverability include only future flows (cash inflows less cash
outflows) directly associated with use and eventual disposal of a given asset. Cash flow estimates are based
on assumptions about employing the long-lived asset for its remaining useful life.

When an asset group consists of long-lived assets with different remaining useful lives, determining the
group’s life is critical to estimating cash flows. Remaining useful life is based on the life of the primary
asset, the most significant asset from which the group derives its cash flow generating capacity. The
primary asset must be the principal long-lived tangible asset being depreciated (or intangible asset being
amortized).

 Example: Asset Impairment

Macy’s paid $6,000,000 for the trademark rights to a specialty line of clothing. After several years, the
book value of the rights is $5,000,000.
Sales for this line of specialty clothing are disappointing. Management estimates that the total future
cash flows from sales will be only $2,000,000.
Due to the disappointing sales, the estimated fair value of the trademark is now only $1,200,000.

 Step 1: Test for impairment: Future cash flows are $2,000,000. This is less than the book value of
$5,000,000. There is an impairment.
 Step 2: Amount of impairment: The book value is $5,000,000. The fair value is $1,200,000. Thus,
there is an impairment loss of $3,800,000.

Week 5 – 21 ottobre

ASSET DISPOSITIONS
Suppose that GM sold assets that had an original cost of $75 million. The accumulated depreciation on
these assets at the time of the sale was $45 million. How does the sale affect the financial statements if the
assets were sold for the following amounts:
1. $30 million
Cash 30 (BS,A+)
Accum. Dep. 45 (BS,XA-,A+)
PPE 75 (BS,A-)
No gain or loss

2. $85 million
Cash 85 (BS,A+)
Accum. Dep. 45 (BS,XA-,A+)
PPE 75 (BS,A-)
Gain from sale 55(IS, NI+)
Gain of $55 million

3. $10 million
Cash 10 (BS,A+)
Accum. Dep. 45 (BS,XA-,A+)
Loss from sale 20 (IS,NI-)
PPE 75 (BS,A-)
Loss of $20 million

 Example: SEARS HOLDING

CORPORATIONS

Consolidated
Statements of Operations
Consolidated Balance Sheet Consolidated Statement of Cash Flows

SEARS, NOTES TO THE FINANCIAL STATEMENTS

Merchandise Inventories
Merchandise inventories are valued at the lower of cost or market.
For Kmart and Sears Domestic, cost is primarily determined using the retail inventory method ("RIM").
Kmart merchandise inventories are valued under the RIM using primarily a first-in, first-out ("FIFO") cost
flow assumption. Sears Domestic merchandise inventories are valued under the RIM using primarily a last-
in, first-out ("LIFO") cost flow assumption. Approximately 58% of consolidated merchandise inventories are
valued using LIFO. To estimate the effects of inflation on inventories, we utilize external price indices
determined by an outside source, the Bureau of Labor Statistics. If the FIFO method of inventory valuation
had been used instead of the LIFO method, merchandise inventories would have been $31 million higher at
February 3, 2018 and $33 million higher at January 28, 2017.
During 2017 and 2016, a reduction in inventory quantities resulted in a liquidation of applicable LIFO
inventory quantities carried at lower costs in prior years. This LIFO liquidation resulted in a decrease in
cost of sales of approximately $6 million and $12 million in 2017 and 2016, respectively.

Impairment of Long-Lived Assets and Costs Associated with Exit Activities

In accordance with accounting standards governing the impairment or disposal of long-lived assets, the
carrying value of long- lived assets, including property and equipment, is evaluated whenever events or
changes in circumstances indicate that a potential impairment has occurred relative to a given asset or
assets. Factors that could result in an impairment review include, but are not limited to, a current period
cash flow loss combined with a history of cash flow losses, current cash flows that may be insufficient to
recover the investment in the property over the remaining useful life, or a projection that demonstrates
continuing losses associated with the use of a long-lived asset, significant changes in the manner of use of
the asset or significant changes in business strategies.
An impairment loss is recognized when the estimated undiscounted cash flows expected to result from
the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the
carrying value of the asset. When an impairment loss is recognized, the carrying amount of the asset is
reduced to its estimated fair value as determined based on quoted market prices or through the use of
other valuation techniques. See Note 13 for further information regarding long-lived asset impairment
charges recorded.

Intangible Asset Impairment Assessments

We consider the income approach when testing intangible assets with indefinite lives for impairment on an
annual basis. We utilize the income approach, specifically the relief from royalty method, for analyzing our
indefinite-lived assets. This method is based on the assumption that, in lieu of ownership, a firm would be
willing to pay a royalty in order to exploit the related benefits of this asset class. The relief from royalty
method involves two steps: (1) estimation of reasonable royalty rates for the assets; and (2) the application
of these royalty rates to a net sales stream and discounting the resulting cash flows to determine a value.
We multiplied the selected royalty rate by the forecasted net sales stream to calculate the cost savings
(relief from royalty payment) associated with the assets.
In our quarterly reports on Form 10-Q filed during 2017, the Company disclosed that if its results continued
to decline it could result in revisions in management's estimates of the fair value of the Company's trade
names and may result in impairment charges.
As a result of recently announced store closures and the further decline in revenue experienced in the
fourth quarter at Sears Domestic, our analysis indicated that the fair value of the Sears trade name was
less than its carrying value. Accordingly, we recorded impairment related to the Sears trade name during
2017 of $72 million, which reduced the carrying value to $359 million at February 3, 2018. We also
recorded impairment charges of $381 million and $180 million in 2016 and 2015, respectively.

 RECAP EXERCISE
A company buys a machine for $75,000
Estimated salvage value: $5,000
Estimated useful life: 10 years
 The company uses straight line depreciation for these types of machines

1) What is the depreciation expense for year 1?

(Cost – Residual value)/Number of years = ($75,000 – 5,000)/10 = $7,000

Depreciation expense of $7,000 on the income statement

2) What is the carrying value of the machine at the beginning of year 3?

Carrying value (net book value) = Cost – Accumulated Depreciation

Accumulated Depreciation = Number of years X Depreciation Expense = 2 X $7,000 = $14,000

3) At the end of year 7, the company sells the machine for $30,000. What is the impact on the income
statement? What is the impact on the cash flow statement?
First, we need to determine the carrying value of the machine (net book value)
Cash in: $30,000
Book value of machine: $26,000

Profit (loss) = $30,000 – 26,000 = $4,000

7 X 7,000 = $49,000

Journal entry:
 Income statement: +$4,000 gain on sale, Net Income will increase (+NI)
 Cash Flow Statement: +$30,000 sale of asset (machine). This will go under Cash Flow from
Investing Activities

Week 6 – 24 October

INTANGIBLE ASSETS
Intangible assets are long-term (long-lived) assets without physical substance that confer specific rights on
their owner.
 Main Characteristic: unlike tangible assets such as land and buildings, an intangible asset has no
material/physical substance (financial assets, which also don’t have a physical substance, are not
classified as “intangibles”)
 Valuation: intangible assets are recorder at historical cost only if they have been purchased. If these
assets are developed internally by the company, they are expensed when incurred.

Intangibles assets are divided in:

 Acquired Intangibles: Patents; Copyrights; Broadcast rights; Trademarks; Customer lists; Franchises;
Goodwill
 Self-created Intangibles: Software development; Movie production; Oil exploration (self-created
intangibles are usually expensed)

Amortization of Intangibles
o Limited/definite life intangibles (e.g., patents) = amortized over their useful/legal life (typically the cost
of intangible asset with a definite life is allocated on a straight-line depreciation)
o Indefinite life intangibles (e.g., customer list, goodwill) = not amortized, however, they are subject to
periodic impairment tests.

GOODWILL
Is the most frequently reported intangible asset and is defined as the cost in excess of net assets acquired
(is the excess of the purchase price of another entity over the fair value of that entity’s net assets).
The term Goodwill means the favorable reputation that a company has with its customers. Goodwill arises
only on acquiring firms’ Balance Sheets. Most specifically, Goodwill arises from factors such as customer
confidence, reputation for good service or quality goods, location, outstanding management team and
financial standing.
From its first day of operations, a successful business continually builds goodwill. In this context, the
goodwill is said to be internally generated and is not reported as an asset. The only way to record and
report goodwill as an asset is to purchase another business.
Goodwill is not subject to amortization. However, it has to be tested periodically for impairment.
For accounting purpose Goodwill is defined as the difference between the purchase price of a company as
a whole and the fair value of its net assets.
 Goodwill = Purchase price of Target Company – Fair market Value of {identifiable assets –
identifiable liabilities}
Ossia: Goodwill = purchase price of Target Company (ossia how much you pay for the company) – (Fair
market Value of identifiable assets – Fair market Value of identifiable liabilities)

 Example 1: Quaker Oat’s purchase of Snapple

On December 6, 1994, the Company purchased Snapple Beverage Corp. for a tender offer price of $1.7
billion. The acquisition was accounted for as a purchase and the results of Snapple beverages are
included in the consolidated financial statements since the date of acquisition. The allocation of the
 purchase price included the following intangible assets along with the related amortization periods.
Amortization is on a straight‐line basis.

Why is the total of

$1.858 (in billions)
greater than the
$1.7 billion
purchase price?

Goodwill = Purchase Price – FMV {Identifiable Assets – Identifiable Liabilities}

1300 = 1700 – (1858 – X)
X = 1458

 Example 2: Amazon Purchases Whole Foods

Amazon paid $13.2 billion for Whole Foods,

which it purchased in August 2017. Of this, $9
billion was allocated to goodwill.

Goodwill = Purchase Price – FMV {Identifiable Assets – Identifiable Liabilities}

9.0 = 13.2 - {7.9 - 3.7}

 Example 3:
Company A enters into negotiations to buy 100% of B’s equity
The individual balance sheets of Companies A and B:

Based on the above information, how much would you pay to acquire 100% of the equity of B?
It depend, perchè non c’è scritto the fair market value (ce lo deve dare Il professore)
 Ora il prof ci ha dato il dato dicendoci: Company A decided to acquire 100% of B’s equity for a price
of $24, in cash. The fair value of B’s assets is appraised at 42.
Quindi adesso possiamo calcolarlo.
Question: What is the amount of goodwill included in the purchase price of 24?
Answer: 7 (the difference between $24, the purchase price, and the fair value of B’s net assets)
> 24 - (42-25) = 24 – 17 = 7.
Goodwill Impairment
 Example:

The Company’s later separation of the Entertainment Group reporting unit into the Video and
Broadband reporting units required additional impairment evaluations prior to and after the
separation, pursuant to which the Company recorded a goodwill impairment charge of $8,253 million,
representing the entire amount of goodwill allocated for the Video reporting unit. The Company also
recorded a $2,212 million goodwill impairment charge for the Vrio reporting unit, representing the
entire amount of goodwill for that reporting unit.
RISULTATO = $10,465,000,000

Can Goodwill be negative?

Ricorda: un ragazzo ha chiesto se Goodwill all’inizio può essere negativo. Il prof ha risposto che si può
esserlo, ma di conseguenza io allora non compro la compagnia. Nel tempo Goodwill può solo crescere non
diminuire, ma se già è negativo io allora non compro la company.

Goodwill is an “Iffy” Asset, why?

Its value is derived (based on) the price management was ready to pay to acquire the other business entity.
Goodwill is not subject to amortization even though it is unrealistic to assume that it would remain
valuable forever. While goodwill is subject to an annual test for impairment, management has an incentive
to avoid impairing the goodwill on the books.

LIABILITIES
The FASB defines liabilities as “probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in the future as a
result of past transactions or events.”
The definition of liabilities touches on the present, the future, and the past: a liability is a present
responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.
 Most liabilities require the future sacrifice of cash (but not all: nonmonetary liabilities)
 Creditors are concerned about liquidity (ability to pay current debts) and solvency (ability to pay long-
term debts).

There are different types of liabilities: Current; Long-term; Commitments and Contingencies; Purchase
Commitments; Loss Contingencies; Warranties

CURRENT LIABILITIES:
Current Liabilities are obligations whose settlement is reasonably expected to require use of current assets
or the creation of other current liabilities. Generally payable within one year from the balance sheet date.
Many current liabilities have a direct relationship to the operating activities of a company, for example:
Operating activity Current liability
Purchase coffee inventory Account payable
Rent store space for coffeehouse Accrued rent
(Included in accrued liabilities)
Employees earn wages Accrued wages
(Included in accrued liabilities)
Customers pay in advance for Deferred revenue
future purchases (Reported as “stored value card liability”)

Typical Current Liabilities:

Accounts payable; Notes payable; Sales taxes payable; Income taxes payable; Employee-related liabilities;
Short-term loans; Dividends payable; Current maturities of long-term debt; Customer advances and
deposits; Unearned revenues (non-monetary); Product-related liabilities (warranties); Salary payable

 Accounts Payable (AP): refer to a company's short-term obligations owed to its creditors or suppliers,
which have not yet been paid.
o Payables appear on a company's balance sheet as a current liability.
o The increase or decrease in total AP from the prior period appears on the company’s cash flow
statement. The other party would record the transaction as an increase to its accounts receivable in
the same amount.

 Accrued Liabilities: are expenses that have been incurred before the end of an accounting period but
not yet been paid.
o Accrued liabilities are recorded by recognizing an expense for the period and an associated liability
o Accrued taxes payable, Accrued Compensation and Related Costs, Payroll Taxes

 Deferred/unearned Revenues: is the cash collected by the company before the related revenues has
been earned.
o Deferred revenues are reported as a liability because cash has been collected from customers, but
the company has not delivered a product or service, and thus the related revenue has not been
earned by the end of the accounting period. The obligation to provide a product or service in the
future still exists. These obligations are classified as current or non-current (long term), depending
on when a company expects to provide the product or service.
 Notes payable: is a written promissory note. Under this agreement, a borrower (the company) obtains
a specific amount of money from a lender (bank or others creditors) and promises to pay it back with
interest over a predetermined time period.
INTEREST:
o Banks and other creditors are willing to lend cash because they will earn interest in return.
o Earning interest by loaning money to others reflects the time value of money ( = principle that a
given amount of money deposited in an interest-bearing account increases over time).
o To the borrower, interest reflects the cost of using someone else’s money and is therefore an
expense. To lenders, interest reflects the benefit of allowing someone else to use their money and
is therefore revenue.
o You need three pieces of information to calculate interest:
1. the principal (i.e., the cash that was borrowed)
2. the annual interest rate
3. the time period for the loan.
 The Interest for the Period formula is = Principal × Annual Interest Rate × Number of
Months / 12 Months
o Interest is an expense incurred when companies borrow money. Companies record interest
expense for a given accounting period, regardless of when they actually pay the bank cash for
interest.

 Current Portion of Long-Term Debt: is the amount of unpaid principal from long-term debt that has
accrued in a company's normal operating cycle (typically less than 12 months).
o It is considered a current liability because it has to be paid within that period.

NON-CURRENT (LONG-TERM) LIABILITIES:

Long-term liabilities include all obligations that are not classified as current liabilities and are generally
payable after one year from the balance sheet date.

Typical Long-Term Liabilities:

Long-term debt; Long-term lease obligations; Post-employment benefit obligations; Deferred revenue;
Deferred tax liabilities
PURCHASE COMMITMENTS:
Purchase commitments are commitments to purchase goods or services at some future date at a fixed
price. Used to protect the company from price increases.
= Gli impegni di acquisto sono impegni ad acquistare beni o servizi in una data futura a un prezzo fisso.
Vengono utilizzati per proteggere l'azienda dagli aumenti di prezzo.

But what if the price falls below the contracted price and the contract cannot be cancelled?
The company is committed to purchasing products or services at a price higher than the current market
value. A company must recognize a purchase commitment if it is probable that it would put the company
in an economic disadvantage.

 Example: In November 2018, Hertz entered into a 2-year contract to purchase at least 10,000 gallons of
gasoline for its car fleet at a fixed price of $3 per gallon.
In 2019, Hertz bought 4,000 gallons under the agreement. By the end of 2019, the market price of gas
dropped to $2.50 a gallon. It was expected that oil prices would be stable through 2020.

- What is the contingent liability at the end of 2019, if any?

There is a contingent liability in the amount of $3,000.
Calcolo: ($3.00 – $2.50) * $6000 gallons = $3000

- How does this affect the 2019 financial statements?

Loss due to purchase commitment 3000 [+Exp, +L]
Purchase commitment liability 3000

- In early 2020, Hertz bought 4,000 gallons of gas under the contract, paying cash. What accounts are
impacted?
Purchase commitment liability 2000 -> calcolo: ($0.50*4000 gallons) [-L, +A, -A]
Gas inventory 10,000 -> calcolo: ($2,50* 4000 gallons)
Cash 12000

- In late 2020, the market price has unexpectedly increased to $3.75 Hertz buys the remaining 2,000
gallons, paying $3.00 per gallon.
Gas inventory 6000
Cash 6000
Purchase commitment liabilities 1000
COGS 1000
CONTINGENCIES (imprevisti):
A contingency arises when there is uncertainty regarding the possible gain (a gain contingency = guadagni
potenziali) or loss (a loss contingency = perdite potenziali) that will ultimately be resolved when one or
more future events occur or fail to occur.
 Examples of Gain Contingencies:
- Possible tax refunds
- Pending court cases with an expected favorable outcome
- Future tax credits due to losses carried forward
 Example of Loss Contingencies:
- Pending court cases with an expected unfavorable outcome
- Pending legislation that may entail additional costs (e.g., environmental legislation)
- Expected obligations arising from previous commitments or guarantees to other parties (e.g.,
purchase commitments or guarantees of other entities’ debt obligations)
- Expected loss due to potential failure of existing customers to pay their debt; Costs associated with
product warranties

Accounting for Contingencies:

There is no recognition of contingent gains, while contingent losses may:
i. not be mentioned,
ii. published in a footnote or
iii. recognized in the financial statements.
The treatment of contingent losses depends on:
 the probability that the event giving rise to the loss will occur and
 the ability of management to estimate the loss.

Loss Contingencies:
1. The possibility of payment is
a) Probable – likely to occur;
b) Reasonably possible – more likely than remote but less than probably; or
c) Remote – the chance is slight.
2. The amount of payment is
a) Reasonably estimable; or
b) Not reasonably estimable
Contingent losses are recognized in the financial statements when they:
1) Are probable and
2) Can be reasonably estimated.
If only one of the conditions is present, publication in the notes to the financial statements is required; but
if the amounts are material or the probability of the loss is remote, there is no need to make a publication.

Reporting Contingent Losses:

A contingent liability is reported as either a current or long-term liability, depending on when management
expects the probable loss to be paid. If the possibility of payment is probable and if one amount within a
range appears more likely, this amount is reported. When no amount within a range appears more likely
than any other amount, the minimum amount is reported and the range of potential losses is published.
 Example: Executive Drycleaners Company is involved in a lawsuit ( = causa legale) as of Dec. 31, 2020. It
is probable that the company will be liable/responsabile for $1.7 million as a result of the lawsuit.
Any payments required to be made will commence two years in the future.
a. How are the financial statements affected?
Loss from Lawsuit $1.7 [+Exp, +L]
Lawsuit Liabilities $1.7
b. What if the likelihood that the company will have to pay the $1.7 million is reasonably possible?
No entry is necessary. The lawsuit will be disclosed in a footnote
WARRANTIES (garanzie) (a contingent liability):
Usually a current liability, but not always.
May be reported as a separate item or may be part of “Accrued expenses and other current liabilities”
 Example: You buy a new HP laptop. It comes with a warranty covering the hardware from defect for
either a 90-day, one-year or two-year period, depending on the product. Such warranties are offered to
increase sales.
The warranties for the computers represent a liability at the time of the sale because it meets the
criteria for reporting a contingent liability.
1. Probable: Warranties almost always require such eventual expenditure
2. Reasonably estimable: Even though the warranty costs that will be incurred during the warranty
period are not precisely known, they can be reasonably predicted base on past experience, industry
statistics, etc.

Accounting for Warranties:

HP introduces a new laptop computer in November 2020 that carries a one-year warranty against
manufacturer’s defects. HP sells $3.0 million worth of laptops in November.

How much does HP “owe” the customers who bought the laptops?

o Based on experience, HP expects future warranty costs to be 2% of revenues. It would record:

Warranty Expense 60,000 [+Exp]
Warranty Liability 60,000 [+L]

o Suppose that in December, HP incurs costs to service the laptops sold in November of $15,000.
Warrant Liability 15,000 [-L]
Cash 15,00 [-A]

o Warranty claims may also be satisfied using employee labor hours, inventory parts, or supplies.

 Example of Warranties: Tesla

The portion of the warranty reserve expected to be incurred within the next 12 months is included
within accrued liabilities and other, while the remaining balance is included within other long-term
liabilities on the consolidated balance sheets.
Warranty expense is recorded as a component of cost of revenues in the consolidated statements of
operations. Due to the magnitude of our automotive business, accrued warranty balance as of
December 31, 2019 was primarily related to our automotive segment.
Accrued warranty activity consisted of the following (in millions):
In 2019, how much
did Tesla pay to fix
problems that
occurred while its
products were under
warranty?
Warranty cost
incurred = 250

In 2019, what was

tesla’s warranty
expense? Provision
for warranty = 555
Week 6 – 28 October

LEASES (leasing):
Companies often lease assets rather than purchase them. When a company leases an asset, it enters into a
contractual agreement with the owner of the asset. A lease is a contractual arrangement where one party
(the lessor) give an asset for use by the other party (the lessee). The lessor receives periodic payments over
an agreed period from the lessee for use of the asset or property.
 Lessor: the owner of the asset that is being leased or rented
 Lessee: the party leasing or renting the asset
Leasing an asset is often a more economical option than purchasing the asset because it requires a much
lower upfront cash outlay.

Types of Lease Agreements:

For accounting purposes, a lessee can lease an asset by signing either a short-term lease (12 months or
less) or a longer-term lease.

 A short-term lease is a lease for 12 months or less (including expected renewals and extensions) that
does not contain a purchase option that the lessee is expected to exercise. A company does not record
a lease asset or a lease liability when it signs a short-term lease.

 Longer-term leases are more common and are classified as:

o Capital Lease (aka Finance or Financial Lease)
A lease in which the lessee acquires full control of the asset and is responsible for all maintenance
and other costs associated with the asset. GAAP requires that this type of lease agreement be
recorded on the lessee’s balance sheet as an asset with a corresponding liability. Any interest and
principal payments are recorded separately in the Income Statement. The lessee assumes both risks
and benefits of the ownership of the asset.
A lease is classified as a Capital (Finance) Lease if it meets any of the following criteria:
1. At the end of the lease term, the ownership either automatically transfers to the lessee or the
lessee can purchase the asset at a bargain purchase price.
2. The term of the lease represents a major part of the remaining life of the asset.
3. The present value of the lease payments over the term of the lease equals or exceeds the fair
value of the asset.
o Operating Lease
A lease in which the lessor retains all the benefits and responsibilities associated with ownership of
the asset. The lessor is in charge of covering everyday operating expenses (such as buying ink for a
printer). The lessee uses the asset or equipment for a fixed portion of the asset’s life and does not
bear the cost of maintenance. Unlike in a capital lease agreement, the lessee does not record the
asset on the balance sheet.
o Sale and leaseback
An agreement where one party purchases an asset or property from another party, and
immediately leases it to the selling party. The seller becomes the lessee, and the entity that
purchases the asset becomes the lessor. This type of agreement is implemented based on the
understanding that the seller will immediately lease back the asset from the buyer, subject to an
agreed payment rate and period of payment. The buyer in this type of transaction may be a leasing
company, finance company, insurance company, individual investor, or institutional investor.
Capital (Finance) leases VS Operating leases:
- Finance lease: Effective control of the leased asset is transferred to the lessee.
- Operating lease: Effective control of the leased asset remains with the lessor.

How do accountants determine if a longer-term lease should be recorded as a finance lease or an operating
lease?

If a lease meets any of the following five criteria, it is considered a finance lease:
1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably
certain to exercise.
3. The lease term is for the major part of the remaining economic life of the underlying asset. . . .
4. The present value of the sum of the lease payments and any residual value guaranteed by the
lessee . . . equals or exceeds substantially all of the fair value of the underlying asset.
5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the
lessor at the end of the lease term.*
The five criteria are aimed at establishing whether the lessor maintains effective control of the leased asset
or whether effective control has been transferred to the lessee. If any of the five criteria are met, then
effective control (i.e., substantially all of the risks and rewards of ownership) is transferred to the lessee
and the lease is a finance lease. If none of the criteria are met, then effective control remains with the
lessor and the lease is an operating lease.

Accounting for Leases (from the Lessee’s Perspective)

A new standard for accounting for leases was recently adopted. Basically, this standard requires that a
lessee recognize a right-of- use (ROU) asset and a lease liability on its Balance Sheet for most leases,
including operating leases. This has had a significant impact on most companies’ Balance Sheets because
leasing arrangements are so prevalent.
Under the new accounting standard:
- All leases with a term exceeding 12 months are capitalized.
- Upon commencement of a capital lease, a liability and an asset are reported on the Balance Sheet.
- The initial balance of the asset and the liability are equal to the present value of the least payments.
- Asset: Called a Right-of-Use (ROU) asset. It is amortized over the term of the lease.

Just remember the two key aspect:

a) Regardless of whether the lease is determined to be a finance lease or an operating lease, the company
must record a lease asset and a lease liability upon signing the lease agreement.
b) Second, the amount recorded as the lease asset and the lease liability is the current cash equivalent of
the required future lease payments.
Lease Expense:
The lease expense depends on the type of lease.
v For Operating Leases:
• The lease (or rental) expense is the contractual periodic lease payment.
• The lease payment is reported as part of Cash Flows from Operating Activities.
v For Capital Leases:
• The lease expense is the sum of two components:
o The depreciation of the ROU asset and
o The interest on the lease liability.
• Each lease payment is considered as consisting of principal and interest.
The principal component appears in Cash Flows from Financing Activities. The interest component
appears in Cash Flows from Operating Activities.

Required Lease Disclosures:

Companies have to provide sufficient information on the financial statements to answer these questions:
- Where are lease-related assets and liabilities reported on the Balance Sheet?
- Where are the lease payments on the Cash Flow Statement?
- What are the expected lease payments in future years?
 Lease Example 1 – Signet Jewelers

Operating Lease ROU Asset:

$1,683.3

Operating Lease Liability:

$338.2 + $1,437.7 =
$1,775.9

Signet occupies certain properties and holds machinery and vehicles under operating leases. Signet
determines if an arrangement is a lease at the agreement’s inception.
Operating leases are included in operating lease right-of-use (“ROU”) assets and current and non-current
operating lease liabilities in the Company’s consolidated balance sheets.
ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities
represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU
assets and liabilities are recognized at commencement date based on the present value of lease payments
over the lease term.
As most of the Company’s leases do not provide an implicit rate, the Company uses its incremental
borrowing rate available at the lease commencement date, based primarily on the underlying lease term,
in measuring the present value of lease payments.
ROU assets are reviewed for impairment whenever events or circumstances indicate that the carrying
amount of the assets may not be recoverable in accordance with the Company’s long-lived asset
impairment assessment policy.
Payments arising from operating lease activity, as well as variable and short-term lease payments not
included within the operating lease liability, are included as operating activities on the Company’s
consolidated statement of cash flows.
Operating lease payments representing costs to ready an asset for its intended use (i.e. leasehold
improvements) are represented within investing activities within the Company’s consolidated statements
of cash flows.
The weighted average lease term and discount rate for the Company’s outstanding operating leases were
as follows:

The future minimum operating lease payments for operating leases having initial or non-cancelable terms
in excess of one year are as follows:

Supplemental cash flow information related to leases was as follows:

 Lease Example 2 - United Airlines

United Airlines enters into a lease agreement regarding a Boeing 787 Dreamliner. The lease calls for 10
annual payments of $20 million, payable at the end of each year. At the end of the 10th year, the title
of the plane transfers to United for $1,000.
The present value of the lease payments, discounted at 5% is $154.3 million.
 Upon inception of the lease agreement, how should this lease be recorded on the financial
statements?
Right-of-use asset 154.3 [+A,+L]
Lease liability 154.3
 Why 154.3? It is the sum of the 20 million payments each year:
20 20 20 20 20 20 20 20 20
PV = + + + + + + + + +
(1+5 %) (1+5 %) (1+5 % ) (1+5 %) (1+5 %) (1+5 %) (1+5 %) (1+5 %) (1+5 % )9 (
1 2 3 4 5 6 7 8
FOR CASE 2: RECAP ABOUT ADJUSTICE ENTRIES

ADJUSTING ENTRIES
Adjusting entries are end-of-period adjustments that reflect timing differences caused by accrual
accounting. The purpose of these is to align the books with “accrual accounting.”
They involve recognition of revenues and/or expenses with no exchange. THEY DO NOT INVOLVE CASH!!!
Adjusting entries are made when a company is "closing the books" and making financial statements for a
period. They record items that have occurred that affect the financial position of the company that would
not have been picked up by the accounting system.
Without adjusting entries, revenues and expenses might not be recorded accurately. As a result, various
balance sheet accounts would not be correct. The financial statements would be misleading.

 Example:

Typical Adjusting Entries

Asset Accounts:
1) Buildings and Equipment - Record depreciation
2) Supplies - Record supply usage
3) Prepaid Expenses - Record rent or insurance expense

Liability Accounts:
4) Interest - Record an interest expense
5) Salaries - Record a salary expense
6) Taxes – Record tax expense
All of these involve recording an expense.
In addition, adjusting entries may involve revenues or the correction of errors.
Week 7 – 31 October

TIME VALUE OF MONEY

Our discussion of longer-term leases raises an interesting question about liabilities: Is the liability today the
amount of cash that will be paid in the future? For example, if I agree to pay you $10,000 five years from
now, should I report a liability of $10,000 on my personal balance sheet? If I can earn interest on my
money, the answer is “no.” To understand why, it is important for you to understand that money invested
in an interest-bearing account grows over time = TIME VALUE OF MONEY
 What is the Time Value of Money? Is a principle that a given amount of money deposited in an interest-
bearing account increases over time.
Most financial decisions are affected by the time value of money because they typically involve
spending money today with the expectation of receiving more money tomorrow

Present Value and Future Value

 Example: Assume that the annual interest rate offered on deposits at your bank is 10%, would you
prefer $1,000 today or $1,000 in one year?
If you take the $1,000 today, you can deposit it in the bank and earn 10% interest over the year. This
will leave you with $1,100 in one year (your initial $1,000 plus $100 of interest)
This is a larger amount than $1,000 in one year.

Referring to the previous example, we can say that:

 Present Value (PV): is the current value of an amount to be received in the future; a future amount
discounted for compound interest.
In the example: is the $1,000. The value of receiving $1,100 in one year at 10%
 Future Value (FV): is the sum to which an amount will increase as the result of compound interest.
In the example: is the $1,100. The value of the $1,000 investment for one year at 10%

 If we define T as the number of years, and k as the annual interest rate, in our case we have:
$ 1,100 FV
𝑃𝑉 = $1,000 = =
1+ 0.1 1+ k

𝐹𝑉 = $1,100 = $1,000 + ($1,000 × 0.1) = $1,000 × (1 + 0.1) = 𝑃𝑉(1 + 𝑘)

Compounding
This refers to an amount of money that earns interest for multiple years, also on the interest earned in
prior years
 Example: Assume you invest $1,000 at 10% for two years. Here we will have T = 2 and k = 0.1
𝐹𝑉 = $1,100 × (1+0.1) = $1,000 × (1 + 0.1) × (1 + 0.1) = $1,000 × (1+0.1) 2 = $1,210
𝐹𝑉 = $1,000 × (1+0.1)2 = 𝑃𝑉 × (1 + 𝑘)T
 Let’s see how much we will have if we invest $1,000 at 10% for 5 years (T = 5, k = 0.1)
𝐹𝑉 = $1,000 × (1+0.1)5 = $1,000 × ( 1.1)5 = $1,610.50

Discounting
The reverse of compounding, discounting provides the present value of a future amount of money.
The Present Value at an annual rate of k of a Future Value to be received in T years:
FV
𝑃𝑉 = T
(1+k )
The Present Value (the value today) of $1,500 to be received in five years at 10%:
$ 1,500 $ 1,500
𝑃𝑉 = = =$ 931.35
(1+0.1) 1.6105
5
The Present Value of a Stream of Cash Flows
Now consider a project that a firm takes on. The project will entail the following stream of cash flows for
the next three years:

Point 0 is the present time (the beginning of the first year); Point 1 is the end of year 1; Point 2 is the end of
year 2; Point 3 is the end of year 3.
 Assuming the annual interest rate is 10%, what is the present value of this stream of cash flows?
We need to discount each cash flow at the appropriate discount factor:
PV $ 100 −$ 150 $ 300
stream of cash flows=¿ + + =$ 192.34 ¿
(1.1)1 (1.1 )2 (1.1 )3

The Present Value of a Perpetual Stream of Cash Flow (Perpetuity)

What is the present value of a stream of cash flows that will continue indefinitely?
 An example of this can be a government bond that costs $1,000 and will pay $100 annually in
perpetuity. But what is the present value of such a bond? If we try to apply the formula for the stream
of cash flows, we will have a problem – it is infinite

For this we have the following formula:

Cash Flow $ 100
PV Perpetuity = = =$ 1,000
Interest rate 10 %

The Present Value of a Growing Perpetuity

A growing perpetuity has cash flows that grow at a constant rate forever.
The constant growth rate is denoted by g
 If we apply a growth rate g = 5% to our prior example:

Each subsequent cash flow will increase by 5%

The formula for a growing perpetuity:

CF 1
PV growing perpetuity = , withk > g
k−g

For our initial $100 cash flow, interest rate k=10%, and growth rate g = 5% we have:
$ 100 $ 100
PV = = =$ 2,000
0.1−0.05 0.05

A growing perpetuity is worth more that a non-growing one. Here we see that half of the present value is
driven by the growth in cash flows ($1,000 compared to $2,000)
FIXED-RATE LOAN (prestito a tasso fisso)
A very common type of loan is a fixed-rate loan.
What makes this loan special is the fact that each payment is of the same amount.
Within that amount there are two components:
 Principal repayment
 Interest payment

 Example:
Assume you want to borrow $5,000 to buy a car. The bank offers you a loan for 5 years. Annual interest
rate is 2%. What would be your annual payment?
Using Excel we can get the payment per year for the loan:
= pmt (interest rate, number of payments, Total amount) = pmt (2%,5,5000) = $1,060

• Payment (from Excel)

• Interest = B.B * interest = 5,000 * 2% = $100
• Principle = Payment – Interest = $1,061 – 100 = 961
• Ending Balance = B.B. – Principle payment = 5,000 – 961 = $4,039
• B.B. of next period = Ending Balance of prior period

 Payment = $1,061

 Interest = B.B * interest

 Principle = Payment – Interest

 Ending Balance = B.B. – Principle payment

 B.B. of next period = Ending Balance of prior period

FINANCIAL REPORTING VS TAX REPORTING
Companies follow GAAP for financial reporting but the Internal Revenue Code when creating their tax
returns.
Following different rules can create what are called book-tax differences (temporary tax difference):
- These differences arise from differences between the accounting rules for financial reporting (GAAP)
and the tax rules administered by the tax authorities regarding revenue and expense recognition.
- These differences are the result of a company reporting revenues and expenses on its income
statement in a different time period than it reports them on its tax return.
- These differences are not due to tax evasion of tax fraud.

Examples of Book-Tax Differences

Permanent Differences
- Income and gains on the Income Statement that are free from tax.
- Expenses on the Income Statement that are not deductible for tax purposes.
Specific examples:
1) Expenses reported on the Income Statement that are not deductible for tax purposes (e.g., fines
resulting from violation of a law, tax penalties, certain start-up costs, a portion of business
entertainment & meal expenses, premium payments on officers’ life insurance policies)
2) Income reported on the income Statement that is exempted/free from taxes (e.g., interest income on
tax-free municipal bonds)
3) Income reported for financial reporting purposes that, for tax purposes, is taxed at a different rate
(e.g., some foreign income)

Temporary (Timing) Differences

- Income or gains that are taxable but not in the same period in which they are reported on the Income
Statement.
- Expenses that are tax deductible but not in the same period in which they are reported in the Income
Statement.
Specific example:
1) Difference between the depreciation expense based on the method used for financial reporting
(usually straight-line) and the depreciation expense based on the method used for tax reporting
purposes (e.g., double-declining balance)
2) Difference between the bad debt expense based on the method used for financial reporting (e.g.,
percentage of credit sales) and the bad debt expense deductible for tax purposes (which is only the
actual write-offs)
3) Difference between the revenue recognized for financial reporting and that recognized for tax purposes
(e.g., a prepayment from a customer is received but the work is not yet completed would not be
recognized as revenue in the financial statements but would be reported as revenue for tax purposes;
 revenue from installment sales is recognized up front on the financial statements but over time for tax
purposes)
4) Difference in the software development expense for book and tax purposes arising from capitalizing
software development costs for financial reporting (resulting in the amortization of these costs in
subsequent years) and their immediate expensing for tax purposes)
Deferred Tax Assets and Deferred Tax Liabilities
 If the difference between financial reporting and tax reporting will result in a higher tax bill in the
future, it results in the creation of a liability = deferred liabilities
 If the difference between financial reporting and tax reporting will result in a lower tax bill in the
future, it results in the creation of an asset = deferred assets

Deferred Tax Liability (DTL)

Deferred tax liabilities represent future tax obligations.
A deferred tax liability recognizes the fact that the company will pay more income tax in the future as a
result of a transaction that occurred in the current period.
A DTL arises when the tax expense reported on the Income Statement is greater than the calculated taxes
owed to the tax authorities.
It is calculated as the company’s anticipated tax rate times the difference between its pretax earning on
the financial statements and its taxable income according to the tax code (That is, the tax on some of the
income will actually be paid in a later year.)

Deferred Tax Assets

Deferred tax assets represent future tax benefits.
Both deferred tax assets and deferred tax liabilities will materialize only if the company has future taxable
income when these temporary differences reverse in the coming years.
If the probability of having future taxable income is lower than 50%, the company has to reduce the
balance of Deferred Tax Asset by a certain amount so as to reflect this low probability. Declining
adjustments are required because of conservatism.
The account used to reduce the net amount of the Deferred Tax Asset is called the “Deferred Tax Asset –
Valuation Allowance.” > There is no valuation allowance (risarcimento) for the Deferred Tax Liability.

Effective Tax Rate

Effective Tax rate = Income Tax Expense / Income Before Tax
The Effective Tax Rate may be higher or lower than the statutory tax rate (currently 21% in the US; 24% in
Italy) due to permanent differences.
The Effective Tax Rate is not affected by temporary differences.

Income Tax Expenses

No deferred taxes are provided for permanent differences because they will never reverse.
In the presence of permanent differences:
Income Tax Expense = (Pretax Income – tax-exempt income + nondeductible expenses) * statutory tax rate
 Example: Determination of the Income Tax Expense
A company uses straight-line depreciation for financial reporting purposes and an accelerated method
of computing depreciation for tax purposes.
As a result, its depreciation expense is lower this year than its deductible expense for tax purposes.
Assume that the overall tax rate is 40%.

Is the difference between book and tax depreciation a permanent or a temporary difference?
Temporary difference

The Income Tax Expense on the Income Statement is determined as:

Pretax income (adjusted for permanent differences, if any) * tax rate

The difference between the Income Tax Expense and the Taxes Due appears on the Balance Sheet as
Deferred Taxes. In this example, a Deferred Tax Liability is created.
The journal entry to record the Income Tax Expense is:
Income Tax Expense 100
Taxes Payable 80 -> 80 = Current component of the Tax Expense
Deferred Tax Liabilitity 20 -> 20 = Deferred component of the Tax Expense
Disclosure Requirements for the Income Tax Expense
1) The “current” and the “deferred” components of the Income Tax Expense have to be published
2) A reconciliation table has to be provided (create) that shows the permanent differences that cause the
difference between the U.S. federal statutory tax rate (21%) and the Effective Tax Rate.
3) A table showing the composition of the Deferred Tax Assets and Liabilities has to be provided.
This shows the temporary (timing) differences that led to the creation of these assets and liabilities
(e.g., depreciation, bad debt expense, etc.
Week 7 – 4 Novembre (esercizi)

Exercise: the Impact of Timing Differences Over the Life of a Single Asset
A company has a single asset with a cost of $1,000, a 4-year life expectancy and no residual value.
It uses straight-line depreciation for financial reporting purposes and an accelerated method for tax
purposes:

The depreciation method is the only difference between

the taxable income and the income on the Income
Statement.
The company’s annual income before depreciation and
taxes is 800, tax rate is 40%.

1) What would the income before taxes look for the “books” and for tax purposes for year 1?

Income statement tax expense: 550 * 40% = 220

Tax return taxes due: 400 X 40% = 160
Difference: 220 – 160 = 60

Does this create an asset or a liability to the company? It creates a deferred tax liability equivalent to 60
RICORDA: Income > tax return = si crea liabilities (deferred tax liability)
Income < tax return = si crea assets (deferred tax assets)

2) What would the income before taxes look for the “books” and for tax purposes for year 2?

Income statement tax expense: 550 X 40% = 220

Tax return taxes due: 500 X 40% = 200
Difference: 220 – 200 = 20

What does this do to the Deferred Tax Liability? Deferred tax liability increases of 20 (so become 80)
Perche 60 (difference year 1) + 20 (difference year 2) = 80

3) What would the income before taxes look for the “books” and for tax purposes for year 3?

Income statement tax expense: 550 X 40% = 220

Tax return taxes due: 600 X 40% = 240
Difference: 220 – 240 = -20

What does this do to the Deferred Tax Liability? Deferred tax liability decreases of 20 (so becomes 60)
Perchè 80 – 20 = 60

4) What would the income before taxes look for the “books” and for tax purposes for year 4?

Income statement tax expense: 550 X 40% = 220

Tax return taxes due: 700 X 40% = 280
Difference: 220 – 280 = - 60

What does this do to the Deferred Tax Liability? Deferred tax liabilities account is canceled
Perchè 60 – 60 = 0
Exercise: Deferred Tax Liability

Suppose that the company decided (incorrectly) to report its tax expense as the amount that it owes to the
IRS based on its taxable income.
There will not be a Deferred Tax Liability, so how does this impact the Balance Sheet?

Balance of the deferred tax Liability

Practice Question on Deferred Tax Liabilities

A company reports the following results from operations for 2021:

The statutory tax rate is 40%.

The difference between the “Book Income” of 200 and the “Taxable Income” of 50 is due to two reasons:
a) A difference in the depreciation methods: The company uses for its financial statements (the “Book”)
straight-line depreciation but uses accelerated depreciation for tax purposes. The straight-line
depreciation for the year is 100 and the accelerated depreciation is 200.
b) The company has tax-exempt income of 50.
Tax Expense = (200 - 50)*40% = 60
Questions
1) What is the tax expense for 2021? Income Tax Expense 60
2) How will the financial statements be impacted by recording the expense? Taxes payable 20
3) What is the effective tax rate for 2021? Def. Tax Liabilities 40
Eff. Tax Rate = (60/200) = 30%
Exercise: Deferred Tax Assets
This example refers to the Accounts Receivable discussion of the Aging of Accounts Method from Week 2.

At the end of Year 1: a Bad Debt Expense of $2,650 was recorded which increased the Allowance for
Doubtful Accounts from $0 to $2,650.
Then, the company decided that an account had become uncollectible and wrote-off $1,700. This left a
balance in the Allowance account of $950.
At the end of Year 2: an aging analysis indicated that the ending balance of the Allowance account should
be $4,200. The Allowance account had to be increased by $3,250 ($4,200 - $950) to bring the balance up to
$4,200.
An adjusting entry was made: Bad Debt Expense 3,250
Allowance for Doubtful Accounts 3,250

For Year 2: How do these entries affect the financial statements and the calculation of taxes owed?
Assume that:
- the company has revenues of $50,000 and expenses of $30,000 (which includes the Bad Debt Expense
of $3,250).
- Income before tax is $20,000.
- Tax rate is 21%.
For tax purposes, the Bad Debt Expense is not deductible, but the write-offs of bad debt are deductible.
This is a timing difference.

Note that the Taxes Due are greater than the Tax Expense. This gives rise to a Deferred Tax Asset
Income Tax Expense = 4,200
Deferred Tax Asset = 326
Taxes Payable= 4,526
Week 8 – 7 November

STOCKHOLDERS’ EQUITY
Legal Forms of Business Organizations: Sole Proprietorship; Partnership; Corporation

CORPORATIONS
The corporation is an entity that is legally separate from its owners. Most corporations have many
stockholders (the people who invest in the corporation – each receive shares of stock that subsequently
can sell on established stock exchanges), although some corporations are owned entirely by one individual.
In the U.S., corporations are formed in accordance with the laws of individual states

Corporations can be:

o Private: Investment is generally concentrated – just a few investors; not subject to regulation (private
corporation is characterized by single or few owners)
o Public: Investment can be made by the general public; stock trades on exchanges; subject to regulation.

Advantages:
 Limited liability: cannot lose more than you invest, even in the event of bankruptcy
 Indefinite life: ownership can be easily transferred; converted to cash
Owners in a sole proprietorship or a partnership can be held personally liable for debts the company has
incurred, above and beyond the investment they have made.

Disadvantages:
 Double taxation: earnings are taxed at the corporate level; dividends are taxed at the individual level
 Greater risk to creditors

The Corporate Form of a Business Organization

Founding a corporation: entity must submit articles of incorporation to the state in which incorporation is
desired.
– Microsoft – incorporated in Washington
– Kodak – incorporated in New Jersey
 67.8% of the Fortune 500 companies are incorporated in Delaware.

Why Delaware?
(1) Quick resolutions of legal issues (judges rather than juries)
(2) Flexible – can incorporate in Delaware without being in the state
(3) Simple, straightforward incorporate process (even online)
(4) Tax friendly – minimal taxes
(5) Privacy (can remain anonymous without identifying directors or officers)
 89% of U.S. based IPOs in 2019 chose Delaware as their corporate home.

Public vs. Private Status

A corporation may become public by offering its securities (stocks or bonds) to the public.
 Advantages of being public
– Ease of raising capital
– Marketability of the investment
– Possibility of equity-based compensation
 Disadvantages of being public
– More regulations to follow (may be costly and restrictive)
– More disclosure and reporting requirements (may allow competitors insight into the company)
– A greater legal exposure.
– Stock market pressures may lead to non-optimal business decisions.
The Benefits and Rights of the Common Shareholders
Common Shareholders have usually the following:
 Benefits:
a. A voice in management: you may vote in the stockholders’ meeting on major issues concerning
management of the corporation.
b. Dividends: if a company pays dividends, you receive a proportional share of the distribution of
profits.
c. Residual claim: you will receive a proportional share of the distribution of remaining assets upon
the liquidation of the company.
 Rights:
1. To share proportionately in profits and losses
2. To share proportionately in management (the right to vote for directors)
3. To share proportionately in assets upon liquidation
4. To share proportionately in any new issues of stock of the same class—called the “preemptive right”

Common Stock and Preferred Stock:

All corporations issue common stock, and some elect to issue a second type of stock called preferred stock.

Common Stock:
Terminology:
 Authorized Stock: is the total number of shares available to sell, stated in the company’s articles of
incorporation
 Issued Stock: is the number of shares that have been sold to investors. A company usually does not
issue all its authorized stock.
The total number of shares can then be divided into two categories:
o Outstanding stock: is the number of issued shares held by investors. Only these shares receive
dividends.
o Treasury stock: is the number of issued shares repurchased by the company.

Issuance of Common Stock (emissione di azione ordinarie):

Shares of common stock may be issued with a par value or without a par value.
PAR VALUE = is the nominal value per share of stock as specified in the corporate charter. It has no
economic importance. The original purpose of assigning a par value to a share of common stock was to
protect creditors by specifying a permanent amount of capital that owners could not withdraw before a
bankruptcy. This permanent amount of capital is called legal capital ( = The permanent amount of capital
defined by state law that must remain invested in the business; serves as a cushion for creditors).
 Laws in many states permit corporations to issue no-par value stock ( = Capital stock that has no par
value as specified in the corporate charter). When a corporation issues no-par stock, legal capital is
defined by state law.

 Example
(Shares and dollars in thousands)
Lost Vikings Corporation issued 300 shares of $10 par value common stock for $4,100.
How does this affect the financial statements?
Cash 4,100 [+A, +E, +E]
Common Stock (par) 3,000
Additional Paid-In-Capital 1,100
 If Lost Vikings had no-par stock:
Cash 4,100 [+A, +E]
Common Stock 4,100

Preferred Stock:
Features often associated with preferred stock:
Nonvoting
Has a pre-determined dividend rate
Preference as to dividends
Preference as to payout in the event of liquidation
 About 20% of the largest U.S. companies have preferred stock.
Snap Inc. (parent company of Snapchat) raised over $1 billion in cash prior to its IPO by issuing
preferred stock to the founder and other early investors.
When the company went public in an IPO, it raised an additional $2.7 billion in cash by issuing common
stock. At that time, the preferred stock held by early investors was converted into common stock.

Preferred stock may be:

 Cumulative (with respect to dividends; dividends in arrears must be paid before any distributions to
common shareholders)
 Participating (with respect to dividends; dividends beyond the stated rate are distributed along with
those to common shareholders)
 Convertible into common stock (allows preferred shareholders to exchange their holdings for common
stock in some prescribed ratio)
 Callable at the option of the corporation (allows the company to buy back the preferred stock at some
pre-specified price)
Preferred stock can also have a par value or be issued without a par value.

Is Preferred Stock Equity Or Is It Debt?

o Under U.S. GAAP, preferred stock is generally included together with common stock in the equity
section of the Balance Sheet and preferred dividends reduce Retained Earnings.
o Under IFRS, preferred stock is generally included in the liabilities section of the Balance Sheet and
preferred dividends are reported in the Income Statement as Interest Expense.
Dividends
The return from investing in a company’s common stock can come from two sources: stock price
appreciation and dividends
Dividends are distributions by a corporation to its stockholders:
– Cash Dividends (Investors pay careful attention to cash dividends. A change in the amount of the
quarterly or annual cash dividend can provide useful information about a company’s future prospects.
An increase in dividends often is perceived as good news. Companies tend to increase dividends when
the company is doing well and future prospects look bright)
– Stock Dividends
– Stock Repurchases

Companies That Don’t Pay Dividends:

 Unprofitable companies: may choose not to pay dividends. The cash may be needed to pay debts or for
strategic purposes.
 Profitable companies: may choose not to pay cash dividends. Companies with large expansion plans
(i.e., growth companies) prefer to reinvest earnings in the growth of the company rather than
distribute earnings back to investors in the form of cash dividends.
Facebook, Alphabet (Google), and Berkshire Hathaway are highly profitable companies that do not pay
dividends, although these companies may buy back their own stock from time to time.

Cash Dividend Policy

Dividend distributions are legally restricted to accumulated profits (Retained Earnings).
Few companies pay dividends in amounts equal to their legally available Retained Earnings. Why?
 Maintain agreements with creditors
 Finance growth or expansion
 Smooth out dividend payments
 Build up a cushion against possible losses
The Board of Directors votes on the declaration of cash dividends = A declared cash dividend is a liability.

Cash Dividend Dates

Declaration date; Record date; Ex-dividend day; Payment date
For companies that pay dividends:
 Declaration date: is the date on which the board of directors officially approves the dividend, so they
announces the next dividend to be paid. The declaration of a dividend creates a binding legal obligation
for the company declaring the dividend ( = As soon as the board declares a dividend, a liability is
created and must be recorded).
 Record date: follows the declaration date; it is the date on which the corporation prepares the list of
current stockholders who will receive the dividend payment. The dividend is payable only to those
names listed on the record date. No journal entry is made on this date.
o The ex-dividend day is the first trading day following the date of record. From that date on, the
stock is traded without the right to the recently declared dividend.
 Payment date: is the date of the actual distribution, so on which cash is disbursed to pay the dividend
liability. Dividends are paid only on shares outstanding.

 Example: Costco company

For this company the Dividend Yield is 0,74% - scritto gia nel testo, ma se lo vuoi trovare si trova:
Dividend Yield: Dividend per Share / Price per Share
 > For Costco: ($0.9 + $0.9 + $0.9 + $0.79)/$471 = 0.74%

Remember: the declaration and payment of a cash dividend reduce assets (cash) and stockholders’ equity
(retained earnings) by the same amount. This observation explains the two fundamental requirements for
payment of a cash dividend:
- The corporation must have accumulated a sufficient amount of retained earnings, or earned a sufficient
amount of income during the period, to cover the amount of the dividend.
- The corporation must have sufficient cash to pay the dividend and meet the operating needs of the
business.

Dividend Distribution
 Example: Costco Declares $10 a Share Special Dividend, Its First Since 2017 By Lawrence Strauss | Nov.
16, 2020, | Barron’s.
Costco has declared a special dividend of $10 a share. The dividend, which will cost the retailer (ticker:
COST) about $4.4 billion, will be paid to shareholders of record as of the close of business on Dec. 2.
The company announced the move after the closing bell on Monday.
The stock sports a small yield of about 0.7%, compared with about 1.6% for the S&P 500. In April, the
company declared a quarterly dividend of 70 cents a share, up by 5 cents, for an increase of nearly
8%-- a sign of Costco’s durability during the pandemic.
Even during the recent Covid-related economic downturn, there has been much speculation about
when Costco would issue its next special. It hadn’t done so since April 2017 when it declared one for $7
a share. It declared another one in early 2015 for $5 a share. And it issued one for $7 a share in 2012.
The company said that its latest special will be funded by existing cash.
For the most part, special dividends are rare. About 2% of the companies in the Russell 3000 index have
paid one this year.

The declaration date is Nov. 16, 2020.

($ in million)
Nov. 15, 2020:
Retained Earnings 4,400 [-E, +L]
Dividends Payable 4,400
The payment date is Dec. 11, 2020.
Dec. 11, 2020
Dividends Payable 4,400 [-L, -A]
Cash 4,400
The ex-dividend day is the first trading day after Dec. 2nd, Dec. 3, 2020.

Stock Dividends (stock splits)

Rather than distribute cash dividends to shareholders, corporations may distribute additional shares of
their own stock to the existing shareholders. These are known as stock dividends or stock splits, depending
on the size of the stock distribution.
Stock dividends are a distribution of additional shares of the company’s stock on a to pro rata basis to
existing shareholders. (Pro rata: means that each shareholders receives additional shares equal to the
percentage of shares already owned = ex: a stockholder with 10 percent of the outstanding shares would
receive 10 percent of any additional shares issued as a stock dividend).
The distribution of stock dividends is done for free – it does not raise cash. Therefore, it doesn’t increase
the owners’ equity.
This is a transfer from Retained Earnings to Contributed Capital. The amount of the transfer is the fair
value of the distributed shares.
Stock dividends are typically expressed as a percentage.
 Example: You own stock in a company that declares a 10% stock dividend. You would receive 1 share
for every 10 shares that you hold.

Week 9 – 18 November

FINANCIAL ANALYSIS – RETURN ON ASSETS (ROA)

How well are managers utilizing the assets in place in the firm?
Analysts and investors use the financial statements to evaluate firm performance, and gain insight into the
company’s business strategy.
We can now discuss a more general framework for evaluating company performance, we start with the
Return on Assets (ROA) measure

Return on Assets (ROA)

How do we interpret the ROA?

 It measures how much the firm earned for each dollar of investment in assets
 It is the broadest measure of profitability and management effectiveness, independent of financing
strategy.
 Firms with higher ROA are doing a better job of selecting and managing investments, all other things
equal.
 Because it is independent of the source of financing (debt vs. equity), it can be used to evaluate
performance at any level within the organization.
 Example: Apple

Some caution is advised

An effective analysis of the performance of a firm (in this case Apple) requires us to understand why its
ROA is changing
For this we can perform an ROA profit driver analysis This is also referred to as DuPont Analysis
We will decompose the ROA into two components:
 Net Profit Margin = Net Income / Net Sales
 Total Asset Turnover = Net Sales / Average Total Assets

Net Profit Margin

Net Profit Margin = Net Income / Net Sales
For each dollar in net sales, how many dollars in net income does the company retain
It can be increased by:
 Increasing sales volume
 Increasing sales price
 Decreasing cost of goods sold and operating expenses
Total Asset Turnover
Total Asset Turnover = Net Sales / Average Total Assets
“For every dollar in total assets, how many dollars were generated in net sales. In other words – how
efficiently were the assets in place used to generate sales”.
It can be increased by:
 Centralizing distribution to reduce inventory kept on hand
 Consolidating production facilities in fewer factories to reduce the amount of assets necessary to
generate each dollar of sales

ROA DuPont Analysis

 Example: Back to Apple

ANSWER

Return on Equity (ROE)

ROA is a measure of the efficiency of the operations of the firm.
But what about leverage? The profitability of the firm can depend on the amount of leverage management
choose to employ.
For this we have Return on Equity (ROE)
Decomposing Return on Equity
Similar to the DuPont Analysis with ROA we can decompose ROE:

 Example: Back to apple

Week 10 – 21 November

STOCK REPURCHASES
Stock repurchases represent a partial liquidation of the company (like dividends).
The extent of the amount that can be repurchased is restricted to the amount of Retained Earnings (similar
to a dividend distribution).
Repurchased shares – “Treasury Stock” – has no voting or earnings rights.
Repurchased shares may be reissued.
Corporations occasionally repurchase their outstanding stock.

Some reasons for repurchases are:

 To have shares available for distribution to executives and employees to award them as part of their
compensation
 To have shares available for distribution to shareholders as stock dividends
 To show management’s confidence in the stock
 To stabilize the market price of the shares
 To save shareholders some tax (applies when the tax rate on dividend income is higher than the tax
rate on capital gains)
 To thwart takeover attempts by reducing the number of stockholders
 To increase profitability measures, EPS and ROE
 As a good investment

Accounting for Stock Repurchases

 Example:
A company buys back 1 million shares of its common stock for $10. Assume that the shares were
originally issued for $6 per share and have a par value of $1 per share.
Example of using the retirement method: WALMART
Example 1 of using the treasury stock method: FEDEX

Reissuing Treasury Stock

 Example: GC Company originally issued 15,000,000 shares of common stock ($1 par) for $25 per share
in 2018.
April 5, 2020: The company repurchased 1,000,000 shares for $28 per share.

Effect of Equity Transactions

Book Value per Share (BVPS) = Common Shareholders’ Equity (on the Balance Sheet) / Outstanding Shares
Net asset value on a per share basis
Earnings per Share (EPS) = Net Income – Dividends to Preferred Stockholders/Wtd. Avg. No. of Common
Shares Outstanding

THE CASH FLOW STATEMENT

How The Financial Statements Fit Together

The Cash Flow Statement

Basically, the statement of cash flows explains how the amount of cash on the balance sheet at the
beginning of the period has become the amount of cash reported at the end of the period

Cash Flows from Operating Activities:

- Received from customers
- Paid to suppliers of goods and services
- Paid for operating expenses
- Paid for taxes

Cash flows from operating activities (from operations) are the cash inflows and outflows that relate directly
to revenues and expenses reported on the income statement. There are two alternative approaches for
presenting the operating activities section of the statement:

 The direct method, that reports the components of cash flows from operating activities as gross
receipts and gross payments. The difference between the inflows and outflows is called net cash
provided by (used by) operating activities.

 The indirect method, that starts with net income from the income statement and then eliminates
noncash items to arrive at net cash inflow (outflow) from operating activities.
Cash Flows from Investing Activities:
- Purchase of Property, Plant and Equipment (PPE)
- Proceeds from the disposal of PPE
- Acquisitions of new businesses
- Proceeds from the sale of businesses
- Purchase of marketable securities
- Proceeds from the sale of marketable securities

Cash flows from investing activities are cash inflows and outflows related to the purchase and disposal of
long-lived productive assets and investments in the securities of other companies. The difference between
these cash inflows and outflows is called net cash provided by (used by) investing activities.
Typical cash flows from investing activities include:

Cash Flows from Financing Activities:

- Issuance of shares
- Repurchasing shares
- Borrowing
- Repaying loans
- Payment of dividends

Cash flows from financing activities include exchanges of cash with creditors (debtholders) and owners
(stockholders). The difference between these cash inflows and outflows is called net cash provided by
(used by) financing activities.
Usual cash flows from financing activities include the following:
Mapping the Balance Sheet into the Cash Flow Statement

 Example:
Presentation of the Cash Flow from Operating Activities
Most companies use the indirect method to present Cash Flow from Operating Activities. In this method
you start from Net Income and adjust for non-cash items.
Some companies use the direct method.
Week 10 – 25 November (esercizi)

What Can Be Learned from the Cash Flow Statement

 Liquidity and solvency
 Prediction of future cash flows
 Cash needs of the company
 Excess Cash (for investments, dividends, stock buybacks, etc.)
 Quality of Earnings
Some useful ratios and measures:
1. Cash-based Current Ratio: CFO / Current Liabilities
2. Cash interest coverage: (CFO + Interest Expense + taxes)/ interest Expense
3. Cash debt coverage: CFO / (Current Maturity of Principal + Interest Expense)
4. Quality of Sales: Cash Collected from Customers / Sales
5. Quality of Earnings: (CFO + Interest Expense + Taxes) / Earnings Bef. Interest, Taxes, Depn & Amort.
(EBITDA)
6. Cash Flow per Share: CFO / Wtd. Avg. No. of Shares of Common Stock Outstanding
7. “Cash” Return on Assets (Cash ROA): CFO / Avg. Total Assets
8. “Cash” Return on Equity (Cash ROE): CFO / Avg. Shareholders’ Equity
9. Free Cash Flow: CFO+ Capital Expenditures (amount paid for fixed assets)
10. Cash Brun Rate: Decrease in the cash account / no. of days