FINANCIAL REPORTING PRINCIPLES

Mark Lang

The goal of this “textbook” is to provide an overview of the principles we will be discussing on each
topic. This document is designed to provide a bare minimum at low cost (both in money and time spent
reading). Please read each section and work the included problems before the associated class. The
concepts will be repeated in the lectures, but most students find that the material benefits from
repetition.

CHAPTER 1: OVERVIEW

The goal of financial reporting is to provide information relevant to estimating the amount, timing and
uncertainty of expected future cash flows. The logic underlying that goal is that a discounted cash flow
model underpins all valuation of financial assets, and estimates of the amount, timing and uncertainty
(through the risk-adjusted discount rate) are necessary to populate that model.

Below is the basic cash flow valuation model. If you haven’t seen it before, don’t worry at this point.
You will see it frequently in finance and accounting.

Vt = CFt+1/(1+r) + CFt+2/(1+r)2 + CFt+3/(1+r)3 + ...

where Vt is value in period t
CFt+1 is expected cash flow in period t+1
r is the discount rate (cost of capital)

All financial reporting can be viewed through that lens; how does this disclosure help me think about
inputs into a discounted cash flow model? In terms of the goals of financial reporting, the amount of
expected future cash flow is the CF term, the timing is in the t+n part (i.e., in what period will the cash
flows be received?), and the uncertainty is the r (how risky is the cash flow stream?). In finance you will
talk extensively about how to determine the riskiness of the firm. Going forward, every time you see a
required financial reporting disclosure, you should be thinking “What does that tell me about expected
future cash flows?” because that is why it is there.

The financial reporting package includes three main financial statements which will be our focus—the
Balance Sheet, Income Statement and Statement of Cash Flows. There is a lot of other disclosure which
we will discuss as well, but the hard part is in understanding the financial statements. In this chapter, it
is not important that you understand all the financial statements since we will cover each
individually in detail. Just try to gain intuition for what they report and why they are required.

BALANCE SHEET

This is the most important financial statement in two ways. First, it is the “primitive” financial statement
in the sense that all other financial statements explain changes in the Balance Sheet. If you understand
the Balance Sheet well, it is easier to understand all the other financial statements. As a result, we will
spend a fair amount of time on the Balance Sheet.

Second, it is (arguably) the most important financial statement in terms of valuation. Before you can
forecast the cash flows of a firm, you need to understand the assets the firm owns and who else has
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claims against those assets (i.e., liabilities). If you are buying equity shares, you are a “residual
claimant;” your claims to dividends are junior to the liability claims. Therefore, you need to understand
both the assets and liabilities to understand the likely value of your claims.

The Balance Sheet is based on the fundamental relation that encapsulates all of accounting in a nutshell:
ASSETS = LIABILITIES + OWNERS’ EQUITY

Assets

Assets are the easiest to understand. They are what the company “owns” that will help to provide the
future cash flows (more formal definitions will be provided in the next chapter). They are divided into
two categories, based on the expected timing of cash flows.

Current Assets are cash or are expected to help to generate cash or be used up within a year. Examples
include cash, accounts receivable and inventories.

Noncurrent Assets are expected to generate cash or be used up in more than one year. Examples include
buildings, land and equipment.

Liabilities and Equity

The other side of the Balance Sheet is harder to understand, but it tells us how the assets are funded or,
put another way, who has claims against the assets. The assets have to be financed somehow, which is
why the Balance Sheet has to balance.

Liabilities

Liabilities are also easy to understand. In simple terms, they are fixed claims against the firm that can, if
unpaid, force the firm into bankruptcy. They are split similarly to assets in terms of timing.

Current Liabilities are expected to require cash (or other) outflows within a year. Examples include
accounts payable to suppliers, salaries payable and short term bank borrowings.

Noncurrent Liabilities are expected to require outflows beyond a year. Examples include long term debt,
pensions and other long term liabilities.

Equity

Equity is the hardest component to understand because it cannot be defined directly; it is a residual.

EQUITY ≡ ASSETS – LIABILITIES

where ≡ indicates that it is definitional.

This is just like the equity in your home. You cannot define it other than as the value of the asset (house)
less the liability (mortgage).

Equity divides into two pieces.

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Contributed Capital: In terms of the equity in your home, part of the equity is there because you
contributed it (e.g., the down payment and principle repayments of your mortgage along the way). In the
case of a firm’s Contributed Capital, it was contributed by shareholders (much of it, for example, in the
initial public offering).

Retained Earnings: In terms of the equity in your home, the other part is there because the house
increased in value over time. In the case of a firm, Retained Earnings represents the increase in equity as
a result of the profitable activities of the firm net of any amounts paid out in dividends. In other words,

Retained Earningst = Retained Earningst-1 + Net Incomet - Dividendst

Change in Retained Earningst = Net Incomet - Dividendst

A good way to think about Contributed Capital and Retained Earnings is to imagine a savings account.
Suppose I own a company that comprises nothing but a savings account with $120 in it and has no
liabilities. Then, the total assets will be $120, the liabilities will be $0 and, therefore, the equity will also
be $120 (the full amount of the assets belongs to me; there are no other claims). Suppose I had originally
put in $100, but over time the account earned interest of $30 and I withdrew $10 of that interest. Then,
the Contributed Capital would be $100 (the amount that I originally put in) and the Retained Earnings
would be $20 (the $30 that it earned net of the “dividend” of $10 that I paid myself). Note also, this tells
me that dividends are nothing more than withdrawals by the shareholders from the firm. They don’t
create or destroy value from the owner’s perspective. They merely reduce the assets (i.e., Cash is paid
out) and reduce the investor’s stake in the firm (i.e., Retained Earnings is reduced) but the investor is not
better or worse off because now they have cash but the value of their interest in the firm has dropped by
the same amount.

Another way to think about the “right hand side of the Balance Sheet” (liabilities and equity) is that it
tells me how the firm is financed. If I want to grow my firm, the ways I could increase total assets are
by: (1) borrowing money short term (Current Liabilities), (2) borrowing money long term (Noncurrent
Liabilities), (3) having the shareholders put in more money by, for example, selling them more shares
(Contributed Capital), or (4) using internally-generated earnings not paid out to the shareholders as
dividends (Retained Earnings). Note that I can only finance growth using earnings if I am not paying out
all of the net income as dividends (i.e., I am retaining some earnings).

INCOME STATEMENT

Now that we have discussed the Balance Sheet, the other statements are easier to understand. They just
explain changes in the Balance Sheet. The Income Statement explains the change in Retained Earnings
before dividends. It is the hardest financial statement to understand because Retained Earnings are hard
to think about. However, the important concept is that Net Income ties back to the Balance Sheet. Ignore
transactions with shareholders for the moment (assume the firm is neither receiving more contributed
capital nor paying dividends). Then, being profitable means that the increase in total assets the firm
generated during the period exceeded any new liabilities they took on. Imagine that you sell something
for more than you paid for it. The asset received (cash) exceeds the asset you gave up (inventory), which
means total assets increased with no change in liabilities, which means you were profitable.

Net Income is explained in terms of:

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Revenues: Conceptually, the assets you received by selling your product.

Expenses: Assets you had to give up (e.g., inventory sold) or liabilities you took on (e.g., wages
payable) to generate the revenues.

Revenues and expenses are telling you something about the Balance Sheet (assets taken in versus assets
given up or liabilities taken on). Note that we do not need an Income Statement to tell us Net Income
(we could figure that out from the change in Retained Earnings on the Balance Sheet adjusted for
dividends). Rather, the Income Statement explains the “why” of Net Income (what were revenues and
expenses that led to the Net Income).

STATEMENT OF CASH FLOWS

As noted above, the other financial statements explain the changes in Balance Sheet accounts. For
example, the Income Statement explains the change in Retained Earnings, but that is a little difficult to
see at first. It is clearer with cash; the Statement of Cash Flows explains the change in cash. The change
in cash comes right off the Balance Sheet, but the purpose of the Statement of Cash Flows is to tell you
why cash changed.

The Statement of Cash Flows breaks the change in cash into three components: Cash from Operations,
Cash from Investing and Cash from Financing. These three components follow the typical structure of
the firm. For a company like Walmart, cash from operations is (loosely) the cash generated by existing
stores (typically positive) and cash from investing is the cash reinvested into new or existing stores
(typically negative because it is a cash outflow). From a practical perspective, cash from financing for
the typical firm can be thought of almost like a plug. If cash from operations is insufficient to cover
investing, then the firm typically needs to borrow money or issue shares to raise cash (cash from
financing is positive). If cash from operations is more than enough to cover investing, then the firm will
pay off debt, pay dividends or repurchase shares from shareholders (cash from financing is negative). As
you will see in your finance courses, firms should only invest in projects that return more than cost of
capital (i.e., that have positive net present values) and shouldn’t hold more cash than they need (because
excess cash doesn’t cover cost of capital), so they will use excess cash to pay off debt or return it to
shareholders.

FINANCIAL STATEMENT FORMAT (United States)

For purposes of this document, we will focus on the typical US format. In class we will talk about other
formats. One of the frustrating parts of this course is that, even within a country, accounting principles
are often vague with respect to format and practice varies, so the discussion here is general. However,
we will see many examples from a wide range of companies in class.

You don’t need to worry too much about the details of format for this course because we will focus on
content rather than format. In problems we work, the format of the Balance Sheet and Income
Statement will generally be provided.

Balance Sheet

By tradition, the Balance Sheet for US firms is typically ordered as Assets then Liabilities then Owners’
Equity. Within Assets, Current Assets are first, followed by Noncurrent Assets. Within Current Assets,

4
you move from most to least liquid: Cash generally comes first, followed by Receivables and Inventory
although it varies depending on a firm’s specific circumstances and is not specified in GAAP. Similarly,
within Liabilities, Current Liabilities come first followed by Noncurrent Liabilities. Within Equity,
Contributed Capital generally comes first followed by Retained Earnings. “Other” generally comes last
in each subsection.

TYPICAL US BALANCE SHEET

ASSETS:

Current Assets:
Cash xxx
Accounts Receivable, net xxx
Inventories xxx
Other Current Assets xxx
Total Current Assets xxx

Noncurrent Assets:
Property, Plant and Equipment, net xxx
Intangible Assets xxx
Other Noncurrent Assets xxx
Total Noncurrent Assets xxx
TOTAL ASSETS: XXX

LIABILITIES AND OWNERS’ EQUITY:

Current Liabilities:
Accounts Payable xxx
Salaries Payable xxx
Current Maturities of Long Term Debt xxx
Other Current Liabilities xxx
Total Current Liabilities: xxx

Other Noncurrent Liabilities

Long Term Debt xxx
Other Noncurrent Liabilities xxx
Total Noncurrent Liabilities: xxx
Total Liabilities: xxx

Owners’ Equity
Contributed Capital xxx
Retained Earnings xxx
Other Owners’ Equity xxx
Total Owners’ Equity: xxx
TOTAL LIABILITIES AND OWNERS EQUITY XXX

5
Income Statement

Generally, the Income Statement starts with Sales Revenue, followed by Cost of Goods Sold (if
relevant), a subtotal for Gross Margin, Other Operating Expenses, a subtotal for Operating Income, non-
operating items such as Interest Income and Expense, a subtotal for Net Income Before Tax, Income Tax
Expense and Net Income.

Typical Income Statement

Sales Revenue xxx

- Cost of Goods Sold - xxx
Gross Margin xxx

- Selling, General and Administrative Expenses - xxx

- Other Operating Expenses - xxx
Operating Income - xxx

+ Interest Income + xxx

- Interest Expense - xxx
Net Income Before Taxes xxx

- Income Tax Expense - xxx

Net Income xxx

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Statement of Cash Flows

The Statement of Cash Flows starts with Cash from Operations, followed by Cash from Investing and
Cash from Financing. For the moment, don’t worry about the specifics other than Cash from Investing
includes activities such as buying and selling property, plant and equipment, while Cash from Financing
includes proceeds from issuance of debt or stock, repurchases of stock, repayments of debt and payment
of dividends.

Typical Statement of Cash Flows

Cash from Operations

… xxx
Total Cash from Operations xxx

Cash from Investing

- Purchases of Property, Plant and Equipment xxx
+ Proceeds from Sales of Prop., Plant and Equip. xxx
- Investments in Other Companies xxx
… xxx
Total Cash from Investing xxx

Cash from Financing

+ Proceeds from Issuance of Stock xxx
- Repurchases of Stock xxx
+ Proceeds from Issuance of Long Term Debt xxx
- Repayments of Long Term Debt xxx
… xxx
Total Cash from Financing xxx

Change in Cash xxx

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Problem 1.1: Preparing a Balance Sheet and Income Statement.

Tar Heel Airlines is a RDU-based airline company serving the East Coast. The accounting records of
Tar Heel Airlines show the following as of December 31 (amounts in millions).

Balance Sheet Items Dec. 31, Yr. 1 Dec. 31, Yr. 2

Accounts Payable $269 $268
Accounts Receivable $100 $87
Current Maturities of Long-Term Debt $12 $9
Long Term Debt $1,236 $1,555
Other Noncurrent Assets $6 $13
Other Noncurrent Liabilities $857 $987
Cash $399 $478
Common Stock $311 $479
Property, Plant & Equipment (net) $4,275 $5,103
Inventories $53 $75
Retained Earnings $2,148 $2,458

Year ended
Income Statement Items Dec 31, Yr. 2
Fuel Expense $848
Maintenance Expense $777
Interest Expense $23
Interest Income $15
Other Operating Expense $1,986
Sales Revenue $5,543
Salaries and Benefits Expense $1,464

a) Reorder the preceding accounts to prepare a Balance Sheet and Income Statement for Tar Heel
Airlines for Dec. 31, Yr. 2.

b) Based on the change in Retained Earnings and Net Income, estimate the amount of dividends paid in
Year 2.

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 CHAPTER 2: BALANCE SHEET

As noted earlier, the Balance Sheet is the most fundamental financial statement and follows from the
equality: ASSETS = LIABILITIES + OWNERS’ EQUITY.

Loosely speaking, assets are things that will help a company generate future cash flows, liabilities are
fixed claims against those cash flows, and equity is the residual value that belongs to the shareholders. It
would be troubling if firms had too much discretion in how to define, and how to measure, assets and
liabilities, so accounting provides definitions and measurement principles. The principles are then
applied to specific topics in the accounting rules.

ASSET DEFINITION (a little loosely):1

1. Expected to provide a future benefit (i.e., aid in generating future cash flows). This one is easy in
the sense that things that aren’t expected to benefit the firm aren’t assets. So, as we will see, if
you have a receivable that goes bad (you no longer expect to collect on it) it no longer satisfies
the definition of an asset and will be removed from the Balance Sheet (written off).

2. The firm has the right to control it (usually title). This one is pretty easy because things you
don’t have rights to and control over wouldn’t be your assets (e.g., a public park that generates
foot traffic to your store provides expected cash flows, but is not your asset).

3. Your rights are based on past transactions or events. This one is controversial, but it basically
says that simply signing a contract generally doesn’t create an asset (or liability). Firms sign
many contracts that don’t immediately create assets or liabilities (called “executory contracts”)
until someone does something.2 When Intel signs a contract to provide microchips, it typically
doesn’t record an asset (or liability) initially. It only reports assets or liabilities once it has
received some money from the customer or provided microchips, and even then it generally only
records the portion for which something has occurred (more on that when we talk about the
Income Statement). Footnotes provide extra detail on contracts that do not satisfy the definition
of assets or liabilities, but affect expected future cash flows.

4. It must be reasonably estimable. This is also controversial. In general, purchased intangibles

(e.g., brands or patents) are recorded as assets, while internally-generated intangibles are not.
For example, when Coke spends on advertising, the resulting brand value does not create an
asset for accounting purposes because there is too much uncertainty about the extent of future
benefits created by the ad. If Coke buys a brand, the brand is considered an asset (in the amount
paid) because it is deemed that we now have a basis for valuing that brand (the amount paid in an
arm’s-length transaction).

1
When I use the word “loosely” I mean that GAAP contains many very specific rules, but I am summarizing the concepts.
For our purposes, the loose definitions will be fine because we are focusing on the general principles. In more advanced
classes, you will see more advanced treatment.
2
In the fall class, we will discuss the new leasing standard, which relaxes the traditional interpretation of this criterion.
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ASSET VALUATION:

1. Assets are valued initially based on what you paid for them (even if you got a bargain). The
acquisition cost is “fully absorbed” in the sense that it includes the all-in cost of acquiring the
asset and getting it ready for purpose, including, for example, shipping, taxes and installation.3
As we will see, this makes manufacturing accounting (or self-constructed buildings, movies, etc.)
a little tricky because you have to keep track of and include all of the materials, labor and
overhead in the value of the asset on the Balance Sheet.

2. Wasting assets (e.g., machinery and equipment) are reduced in value over time as they are used
up through depreciation. Land is not considered to be a wasting asset and is not depreciated.

3. All assets are subject to an impairment test. If an asset drops in expected value below the
carrying value, you reduce the value down based on the present value of the cash flows you
expect to receive from the asset (typically based on how you plan to use it) and take a loss on the
Income Statement for the difference. Most assets are not revalued upwards.

4. Some assets that are easy to value are revalued (up or down) every period to what they are worth
typically based on market trading prices (e.g., financial instruments such as bonds, stocks and
derivatives). This is called “mark-to-market” accounting, and we will cover it in more detail at
the end of the course.

3
If you bought a piece of equipment for $100 and the purchase price included shipping and installation, you would record the
asset at $100. If you bought the equipment for $80, but separately paid $20 in shipping and installation, you would still
record the asset at $100 (= $80 + $20).
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Problem 2.1: Asset recognition and measurement.

The improving economy, his love for the Tour de France, and the lucrative leisure industry prompted
Bill Weld to start a luxury cruise business. These are the transactions that relate to Weld Cruises, Plc.
Indicate whether each of these transactions immediately gives rise to an asset. If Weld Cruises
recognizes an asset, identify the amount, whether it’s a current asset or a noncurrent asset, and the
offsetting account to keep the Balance Sheet in balance.

a) Weld Cruises’ board of directors holds a meeting in which they decide to purchase ten Solaus
cruise ships, costing $530 million. No money or ships change hands at this point.

b) Weld Cruises places an order with the ship manufacturer for ten cruise ships which will cost
$530 million. No money or ships change hands at this point.

c) Weld Cruises pays Solaus $30 million as a deposit on the ships it ordered in (b). The ships will
be delivered in 18 months.

d) Weld Cruises prepays $110 million to obtain docking rights for the next ten years at the port of
Le Havre in France.

e) Weld Cruises purchases new on-shore docking equipment costing $105 million by writing a
check for $20 million and borrowing the other $85 million with a loan due in ten years.

f) Weld Cruises issues common stock (sells it to investors) and receives $260 million in cash.
Weld Cruises uses the entire capital raised to acquire a used ship from a bankrupt regional cruise
liner. The carrying value of the ship on the bankrupt company’s books was $90 million.

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Problem 2.2 (extra problem)

Asset recognition and measurement: The following are hypothetical transactions for Kraft, an
American grocery conglomerate. Indicate whether each transaction immediately gives rise to an asset
under U.S. GAAP. If Kraft recognizes an asset, state the account title, the amount, and the classification
of the asset on the balance sheet as either current or noncurrent asset.

1. Kraft spends $100 million on Research and Development to develop a new calorie-free
mayonnaise. Half of the total was for research, and the other half on development. The R&D is
successful, and Kraft acquires a patent on this new product.

2. Kraft invests $600 million in a government bond. The bond will pay back $1,000 when it
matures in 5 years. Kraft will hold the bond to maturity.

3. Kraft pays $10 million for an option to purchase land in Brazil, where the company intends to
build a distribution center to serve Latin America. The option gives Kraft the right to purchase
the land for $500 million at any point during the next five years.

4. Two months before year-end, Kraft pays MetLife $240 million to insure its U.S. plants. The
amount paid is to cover one year of premiums ($20 million/month) taking effect immediately.

5. Kraft receives notice that a supplier has shipped sugar to Kraft. The invoice is for $500 million
and payment is due in 30 days. The supplier retains title to the sugar until it is received by Kraft.

6. Kraft signs a 5-year employment contract with its CEO for a package valued at $20 million per
year. Of this amount, $4 million is base salary. The rest is expected bonus and deferred
arrangements. No cash has changed hands and the contract begins next year.

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LIABILITY DEFINITION:

The liability definition mirrors the asset definition because one person’s liability will typically be
another person’s asset.

1. Expected to require future outflows of cash, services or other assets. This one is fairly obvious.

2. The firm has an obligation to pay. This one is pretty easy. You typically won’t record a liability
if it is entirely voluntary.

3. Your obligation is based on past transactions or events. Simply signing a contract does not
typically immediately create a liability (or asset).

4. It must be reasonably estimable. Most litigation, for example, is not recognized as a liability until
it is clear how much you will owe given the vagaries of the legal system.

LIABILITY VALUATION:

Current liabilities (e.g., salaries payable) that don’t have stated interest are generally recorded at the full
amount expected to be paid (it is not worth discounting for the time value of money). Noncurrent
liabilities are carried based on the present value of the amount expected to be paid. That may seem
strange initially, but it merely means that, if I borrow $100 from the bank to be repaid in 10 years plus
interest, I record the liability at the principal amount borrowed ($100) rather than the full amount I
expect to repay (principal plus interest). For something like a pension, it means that the liability is the
discounted present value of the amount expected to be paid, determined by an actuary. Don’t worry
about it much now. We will develop the concept in more detail when we talk about interest expense on
the Income Statement.

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Problem 2.3: Liability recognition and measurement

The following relate to Cami Circus, a Washington DC based circus and performance firm. Indicate
whether each transaction immediately gives rise to a liability, the amount of the liability, whether it is a
current liability or a noncurrent liability and the offsetting account to stay in balance.

a) Cami Circus places an order over the phone with a printing company totaling $100,000 for
posters and banners for the next season. No cash or product has changed hands.

b) Cami Circus receives the print material ordered in (a), along with an invoice for $100,000. Title
passes at the time of receipt.

c) Cami Circus receives $2,080,000 in cash for season tickets sold in advance for next season’s
performances.

d) Cami Circus signs a two-year contract with a renowned clown at a salary of $110,000 per year.
The contract starts running at the beginning of next year and the first payment will be made then.

e) A child is traumatized by a scary clown. Cami Circus receives notice from the child’s attorney
that a lawsuit has been filed for $12 million.

f) Cami Circus signs a two-year contract with Dr. B., a renowned marketing professor, who will
help build the online presence for Cami Circus for $150,000 per year. The contract will begin
next year, but Dr. B. insists on, and receives, payment today for the first year’s compensation of
$150,000.

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Problem 2.4 (extra problem)

Liability recognition and measurement: The following transactions relate to CMPC, a pulp and paper
company headquartered in Chile. Indicate whether each transaction immediately gives rise to a liability
under U.S. GAAP. If accounting recognizes a liability, state the account title, the amount, and the
classification of the liability as either current or noncurrent liability. CMPC reports in millions of U.S.
Dollars.

1. CMPC issues 10 million shares of $2 par value common stock for $50 million.

2. CMPC signs a contract to purchase $50 million of merchandise from a supplier over the next two
years. One month later, CMPC places an order for $20 million of this merchandise. The
merchandise has not yet been received.

3. CMPC signs a contract to purchase land and a factory from Arauco for $2,000 million.

4. CMPC receives a check for $200 million from one of its customers. The associated product will
be produced and shipped next month.

5. Refer to event (4), but now assume that CMPC will deliver 50% of the merchandise next month
and the remainder 2 years from now.

6. CMPC borrows $30 million from Santander Bank, payable in equal installments over the next 3
years and bearing interest at an annual rate of 7%.

15
EQUITY DEFINITION AND VALUATION:

Once we’ve defined and measured assets and liabilities, we don’t have much more to say about
shareholders’ equity since OWNERS’ EQUITY = ASSETS – LIABILITIES. Recall that there are two
primary categories of equity. Contributed Capital is valued at the amount the investors put into the firm.
Retained Earnings is the sum of net income since the firm was founded net of dividends paid (i.e.,
earnings are “retained” if they are not paid out in dividends).4

BASIC BOOKKEEPING

Notice that, for ASSETS = LIABILITIES + OWNERS’ EQUITY to hold, you can never have one thing
happen without another thing happening (that is why it is called “double-entry bookkeeping”). More
than 500 years ago, the merchants of Venice recognized that to stay in balance:5

any time you have one (or more) of these: ASSET↑ or LIABILITY↓ or OWNERS’ EQUITY↓
you have to have an equal amount of these: ASSET↓ or LIABILITY↑ or OWNERS’ EQUITY↑

They decided to call the first row debits and the second row credits (from the Latin). Debits and credits
are not intuitive; they just reflect a rule. In journal entries and t-accounts, by convention, debits go on
the left and credits go on the right. As long as debits = credits, your Balance Sheet has to balance.

Just write down the rule and follow it blindly until you get used to it.

Debits (on left): ASSET↑ LIABILITY↓ OWNERS’ EQUITY↓

Credit (on right): ASSET↓ LIABILITY↑ OWNERS’ EQUITY↑

So, for example, if you buy inventory for cash, you have ASSET↑ (inventory) and ASSET↓ (cash), or
(1) Inventory (debit or dr.) 100
Cash (credit or cr.) 100

Buy inventory on account, you have ASSET↑ (inventory) and LIABILITY↑ (accounts payable), or
(2) Inventory 100
Accounts Payable 100

Pay off accounts payable, you have LIABILITY↓ (accounts payable) and ASSET↓ (cash), or
(3) Accounts Payable 100
Cash 100

Issue common stock, you have ASSET↑ (cash) and OWNERS’ EQUITY↑ (Contributed Capital), or
(4) Cash 100
Contributed Capital 100

4
All accounts on the Balance Sheet are cumulative since the Balance Sheet measures the total in an account at the end of the
period, which is the sum of everything that has gone into and out of that account over the life of the firm.
5
Friar Luca Pacioli is generally credited as the “father of accounting” for a treatise included in his book "Everything about
Arithmetic, Geometry, and Proportions," published in 1494. Accounting today is remarkably similar to accounting in 1494.

16
The above transactions, (1) through (4), are typically referred to as journal entries. When we work
problems, we will use the debit/credit convention. It serves two purposes. First, if debits = credits, the
Balance Sheet is in balance barring math errors (it may be wrong, but it will balance). Second, when
preparing a Balance Sheet, we will transfer our journal entries into “t-accounts,” add them to the
beginning balances and compute the ending balances for the Balance Sheet. Using the preceding four
transactions as an example, with the transaction numbers in parentheses, the following are the associated
effects in terms of the t-accounts (debits on the left, credits on the right).

Cash Inventory Accounts Payable Contributed Capital

Beg. Bal. = x Beg. Bal.= x Beg. Bal.= x Beg. Bal.= x
(4) 100 (1) 100 (1) 100 (3) 100 (2) 100 (4) 100
(3) 100 (2) 100
End. Bal.=x-100 End. Bal.=x+200 End. Bal.= x End. Bal.=x+100

Note that the assets begin and end with debit balances because positive amounts in asset accounts are
debits. Liabilities and equities typically begin and end with credit balances because positive amounts in
liability and equity accounts are credits.

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Problem 2.5: Dual effects of transactions on the Balance Sheet equation and journal entries.

Barbara Ann Films (BAF), a production house, records the following transactions during the year.
Please (a) indicate the effects of the below transactions on the Balance Sheet equation, indicating the
change in assets, liabilities and shareholder’s equity and (b) provide the associated journal entries for the
transaction (debits and credits). You may ignore interest. Don’t worry about account titles.

(1) BAF buys a studio for $3 million financed with $3 million of short-term debt due in 9
months.

(2) BAF issues 30 million shares to investors in exchange for a total of $90 million in cash.

(3) BAF buys four Eurocopter EC120 helicopters for aerial shooting purposes financed with $8
million in short term debt.

(4) BAF buys visual equipment for $200 million with cash, and buys audio equipment for $300
million financed with long term debt due in ten years.

(5) BAF pays the seller in transaction (1) the $3 million due (assume there is no interest owed).

(6) BAF pays Eurocopter $4 million (half the amount due) in cash from transaction (3). BAF
satisfies the other half ($4 million) by issuing common shares to Eurocopter.

18
Problem 2.6: Recording transactions in T-accounts and preparing a Balance Sheet.

Kute Fabrics Brand Store (KFBS) is a fashion retail chain founded by UNC to generate revenue. KFBS
plans to open its first retail store on the Outer Banks in December. Transactions of KFBS during
November in preparation for the store opening in December appear below. Prepare (a) the journal entries
for each transaction and post them to the t-accounts below and (b) a Balance Sheet for KFBS on the last
day of November on the sheet provided. As an aside, you only need to use the t-accounts with names on
them (the others are there in case you decide to split things up differently than I did).

(1) November 1: KFBS receives $500,000 from UNC in exchange for all of its common stock.

(2) November 2: KFBS pays another firm $30,000 for a trademark, and pays an intellectual
property lawyer $6,000 to register it. The trademark is good for six years beginning
December 1. Recall that we value assets at the all-in cost of acquiring them and getting them
ready for use.

(3) November 3: KFBS signs a lease to rent land and a building for $25,000 a month. The rental
period begins December 1. KFBS pays $50,000 on November 3 for the first two months’ rent
in advance.

(4) November 10: KFBS buys hurricane insurance coverage from Safe Islands Insurance
Company starting December 1 and pays the one-year insurance premium of $12,000.

(5) November 11: KFBS orders clothing from various suppliers at a cost of $300,000. No cash or
merchandise has yet changed hands.

(6) November 21: KFBS receives and takes title to the $300,000 of clothing ordered in part (5).
KFBS has 30 days to make payment.

19
 (7) November 22: KFBS discovers that clothing costing $20,000 from part (6) was damaged in
shipping and returns the items. The supplier forgives $20,000 of the amount owed.

(8) November 24: KFBS pays $200,000 of the remaining accounts payable for the clothing that
was received in part (6). KFBS receives a 2% discount for prompt payment, so they only
have to pay $200,000 x .98 = $196,000 to satisfy the obligation (i.e., the discount is $4,000).
GAAP treats discounts as a reduction in the acquisition cost (the asset is recorded at the
amount actually paid). Note that at the end of these transactions KFBS still owes $80,000 of
the original $300,000.

Cash Inventory Prepaid Rent and Insurance

Trademark

Accounts Payable Contributed Capital

20
KFBS Group Balance Sheet
ASSETS Nov. 30
Cash
Inventory
Prepaid Rent and Insurance
Total Current Assets

Trademark, net
Total Noncurrent Assets
TOTAL ASSETS

LIABILIITES AND EQUITY

Accounts Payable
TOTAL LIABILITIES

Contributed Capital
TOTAL EQUITY
TOTAL LIABILITIES AND EQUITY

21
Problem 2.7 (extra problem)

Dual effects of transactions on the balance sheet equation and journal entries: Bale is a U.S. steel
producer that applies U.S. GAAP and reports its results in millions of U.S. dollars. During the year, Bale
engaged in the following transactions.

1. Bale issued 7 million shares of stock for $60 cash per share. The par value of the stock was $5.25
per share. You may combine par value and excess of par.

2. Bale purchased $500 million of merchandise inventory, of which $150 million was paid for in
cash and $350 million was on account.

3. At the end of Year 10, Bale purchased land with a cost of $350 million and a factory with a cost
of $800 million from Toto Steel. Bale paid $500 million in cash and signed a note payable for
the remaining $650 million.

4. Bale paid $50 million in cash for a one-year insurance policy covering the land and the factory
bought in transaction (3). The policy takes effect at the beginning of the following year.

5. Bale paid cash of $350 million to the suppliers in transaction (2) for its purchases on account.

a. Show the effects of these transactions on the balance sheet during the year using this format:

Assets = Liabilities + SH Equity

+ $420 $0 +$420

b. Record the journal entries for each of the transactions during the year.

22
 CHAPTER 3: INCOME STATEMENT

The Income Statement is the hardest statement to understand. The difficulty has to do with the fact that
the Income Statement explains the change in Retained Earnings which is, itself, based on a residual
(Assets minus Liabilities). The litmus test is whether you understand what the following journal entry is
telling you.

Rent Expense (Income Statement Expense) 100

Rent Payable (Liability) 100

It takes a while, but if you understand that journal entry, it shows that you understand the gist of the
Income Statement. The first line tells you that rent was an expense of the period (you used the building
during the period) which reduces profitability and, therefore, Owner’s Equity. (Note that the expense is
debited, indicating that Owner’s Equity is being reduced, as with all expenses). The second line tells you
that you haven’t paid the rent for the period yet. If you used the building during the period, you would
record Rent Expense on the Income Statement irrespective of when you paid for it (i.e., Rent Expense
would always be the debit). In the preceding case the credit was Rent Payable because you hadn’t paid
for it yet (you have an unavoidable obligation based on a past event). The credit could, alternatively,
have been Cash (if you paid for it during the period of use) or Prepaid Rent (if you had paid for it in a
previous period and were using up the Prepaid Rent asset this period).

The most difficult concept in accounting is in understanding when something belongs as a Revenue or
Expense on the Income Statement. There are two ways to think about it (two sides of the same coin).

1. Does it seem like it belongs on the Income Statement (e.g., is it a Revenue or Expense of the
period)? Note that not everything that appears on the Income Statement involves cash this
period. Rent is an expense of the period in the preceding example because we used the building
to generate revenues during the period. It doesn’t matter if we paid the rent prior to the period,
paid it during the period, or still owed it at the end of the period, the rent is still a cost of doing
business during the period and belongs on the Income Statement. Note also that, if we based the
expense on the timing of the cash payment, you could pretty much get any profit you wanted by
timing the payment of expenses. However, GAAP requires you to record the expense based on
the period when the benefit was received, so it doesn’t matter when the cash was paid.

2. Does it have to be on the Income Statement? Note, in the preceding rent example, at the end of
the period we have something that satisfies the definition of a liability (unavoidable obligation,
etc.). Therefore, we have a credit looking for a debit to stay in balance. Using our debit/credit
rule, it could in theory be we have an asset (e.g., prepaid rent). However, the rent provided a
benefit in the past, so it is not an asset at the end of the period. It could be another liability that
went away, but we can see that that didn’t happen. Therefore, the debit must be to shareholders’
equity. In theory it could be a reduction in Contributed Capital (e.g., we repurchased shares), but
we didn’t do that. Therefore, it must be an expense of the period. This might seem like a
roundabout approach, but it is the way the standard setter thinks about the Income Statement: it
is whatever is left over after we account for all of the changes in assets and liabilities on the
Balance Sheet during the period.

These concepts are difficult initially (they are the most difficult concepts in accounting), but we will see
them illustrated repeatedly through examples.

23
An Aside on Temporary Accounts

Take a simple merchandising example. Suppose Walmart has a toaster in inventory that they bought for
$80. Suppose Walmart sells the toaster for $100 cash. There are two easy pieces of the journal entry; the
cash received is a debit and the inventory sold is a credit:

Cash $100
Inventory $80
???? $20

What is the other $20 credit? Let’s apply the two tests:

1. Does it sound like it belongs on the Income Statement? Clearly yes, because selling for more
than you paid implies a profit.

2. Does it have to be on the Income Statement? Cash came in for $100 and inventory went away for
$80, so we are out of balance by $20.6 In theory the credit could be that Walmart gave up another
asset for $20, but they didn’t. Or, maybe they took on another liability, but assuming there was
no warrantee (more on that later), they took on no liability. By process of elimination, that means
the credit is to Owners’ Equity. Was it Contributed Capital? No, the purchaser did not get shares.
Therefore, it must belong in Retained Earnings and, therefore, on the Income Statement.

So, what gets credited? Technically, it is Retained Earnings and if we took it straight to Retained
Earnings, our Balance Sheet would be correct.

Cash 100
Inventory 80
Retained Earnings 20

However, remember that the Income Statement helps us understand the pieces of the change in Retained
Earnings (the Revenues and Expenses) not just the net effect. In other words, we don’t just want Net
Income of $20, we want to know the components (I am assuming no other expenses):

Sales Revenue 100

Cost of Goods Sold 80
Net Income 20

To retain the necessary information to fill out the lines on the Income Statement, we use “temporary
accounts,” which are subaccounts in Retained Earnings to keep track of the pieces during the period.
They are called “temporary” because they start and end with zero balances so they only measure the
revenues and expenses that occurred during the period. The Balance Sheet accounts are “permanent”
because they always carry over from period to period (they are cumulative).

6
As an aside, some students want to reduce inventory by $100, but that doesn’t make sense because the toaster is only on the
books for $80.
24
It is very important that you do not attach more significance to temporary accounts than they deserve.
They are just used to keep track of the pieces of the change in Retained Earnings during the period so
that you have enough detail to prepare the Income Statement. It would be fine to just record transactions
directly to Retained Earnings from the Balance Sheet’s perspective, but you need to have enough detail
to prepare the Income Statement. Conceptually, you maintain a temporary account for every line on the
Income Statement to ensure enough detail to complete the Income Statement. So, here is how it works:

(1) Cash 100

Sales Revenue (Revenue, part of Retained Earnings) 100

(2) Cost of Goods Sold (Expense, part of Retained Earnings) 80

Inventory 80

That provides enough detail to prepare the Income Statement:

Income Statement

Sales Revenue 100

- Cost of Goods Sold - 80
Net Income 20

Then, at the end of the period, once the Income Statement is prepared, you record the “closing entry” to
zero out the balances in all revenues and expenses so they begin the next period with zero balances:

(3) Sales Revenue 100

Cost of Goods Sold 80
Retained Earnings 20

Notice what happens in the t-accounts. I’ve noted the first two entries with (1) and (2), the closing entry
with CE and have ignored the Cash and Inventory t-accounts for simplicity.

Sales Revenue Cost of Goods Sold Retained Earnings

Beg. Bal. = 0 Beg. Bal. = 0 Beg. Bal.
CE 100 (1) 100 (2) 80 CE 80 CE 20

End. Bal. = 0 End. Bal. = 0 Beg. Bal. + 20

We ended up with zero balances in the Revenue and Expense accounts, as well as the $20 increasing
Retained Earnings, but we did so in enough detail to prepare an Income Statement. The closing entry is
recorded as the last journal entry at the end of the period after all of the other entries have been recorded
and the Income Statement has been prepared, to zero out the temporary accounts and move Net Income
to Retained Earnings.

25
REVENUE AND EXPENSE RECOGNITION

“Accrual” accounting refers to the notion that revenues are recognized when earned and expenses are
recorded when incurred, not necessarily when cash flows. Since they aren’t directly linked to the timing
of cash flows, we need to define when to recognize revenues and expenses. The important point is
that, over a long enough period of time, items that hit the Income Statement also hit cash from
operations or cash from investing. As a result, the issue with accruals is timing.

Revenue Recognition

In general, revenue recognition anticipates a journal entry like the following:

Asset XX
Revenue (Income Statement) XX

Therefore, to book revenue, two things have to be true.

1. You have to have received something that satisfies the definition of an asset (or in rare cases a
reduction of a liability). Fraud often occurs with respect to this criterion when a company claims
to have an account receivable even though it isn’t actually owed money. For example,
backdating a credit sale that takes place in the first week of the current quarter into the previous
quarter is fraudulent because there was no true account receivable at the end of the previous
quarter. Similarly shipping a product to a customer who hasn’t yet ordered it and recording a
sale anyway is typically fraudulent because you don’t have the right to receive payment.7

2. Even if you have received an asset (e.g., cash), that isn’t enough to record revenue; you must
have “earned” it. If, for example, you have received cash, but still have an unavoidable
obligation to provide a good or service, the credit should be to a liability, not a revenue. If your
gym sells you a two-year membership on December 31 for $240 cash up front, the gym should
book the cash and a liability (often called “Advances from Customers,” “Deferred Revenue” or
“Unearned Revenue”) initially. Then, each month, the gym would reverse out $10 of the liability
as it provided the promised service and book the $10 as revenue. The liability is often called
“Deferred Revenue” because it only becomes “Revenue” as it is earned.8

The criteria sound simple, but revenue recognition is the most common source of accounting fraud
because there are strong incentives to inflate profits and revenue recognition can be a gray area.
There are more specific accounting rules written on revenue recognition than on any other topic.

7
In some industries, customers can be forced to take inventory whether they want it or not. For example, car dealers must
often take a certain number of cars from the manufacturer irrespective of whether they want them. In that case, the
manufacturer could record revenue when they ship the cars because the dealer is legally obligated to pay for them.
8
In some cases, contracts are “bifurcated.” For example, when you buy an iPhone, Apple records revenue for the value of
the phone itself and a liability for the value of upgrades, etc., that they promise to provide over the life of the phone.
26
Given that the Income Statement has to add up to Cash from Operations + Cash from Investing, there
are only three possible timing scenarios. Consider an example in which we provide a consulting service
(so we don’t have to worry about cost of goods sold):

Receive cash at the time of sale:

Cash 100
Revenue (Income Statement) 100

Receive cash before the time of sale:

When cash is received:

Cash 100
Advance from Customer (Liability) 100

Later, when service is provided:

Advance from Customer (Liability) 100

Revenue (Income Statement) 100

Receive cash after the sale:

When service is provided:

Accounts Receivable 100

Revenue (Income Statement) 100

Later, when cash is received:

Cash 100
Accounts Receivable 100

27
Problem 3.1: Revenue Recognition Problem

Jolly Belly (JB) is a weight management center in Raleigh, NC with world-class surgeons and dieticians.
JB recognizes revenues when services are delivered. The following select transactions occurred during
the year. Fill in the attached matrix indicating when the cash flow occurred and when the revenue would
be recognized. What journal entries would JB have recorded in February, March and April?

1) Collects $20,300 cash from customers during March for consultation and slimming sessions
provided in February.

2) Collects $1,000 cash from a customer during March for a session to be delivered in April.

3) Rents space in its store to a low calorie restaurant for $3,000 a month, effective March 1.
Receives $6,000 cash on March 1 for two months’ rent. The rent covers March and April.
(There are various ways of combining journal entries—I don’t care how you combine them
as long as the debits and credits add up correctly during the period.)

28
 4) Provides slimming services during March on account, for which JB will collect $14,000 cash
from customers during April.

5) Rents space in its store to a small fitness equipment retailer for $4,000 a month, effective
March 1. JB will be paid for March and April rent ($8,000 in total) on April 1.

6) Collects $4,200 cash during March from customers for services provided during March.

Transactions February March April

1 Cash
1 Revenue
2 Cash
2 Revenue
3 Cash
3 Revenue
4 Cash
4 Revenue
5 Cash
5 Revenue
6 Cash
6 Revenue

29
Problem 3.2 (extra problem)

Revenue recognition: Agropur Cooperative, a Canadian dairy cooperative, recognizes revenue at the
time it sells products or renders services. Indicate which of the following transactions or events
immediately give rise to Agropur’s recognition of revenue.

1. Agropur spends $20 million to develop a technique to transform a by-product of casein into
ethanol. Agropur expects the new technique to generate additional sales of at least $5 million
starting next year.

2. The technique proves to be successful and Agropur signs a new contract for ethanol sales worth
$500 million.

3. Agropur finishes the pasteurization process for an order of 15,000 liters of milk it will deliver to
Walmart next week. The selling price of the milk is $30,000, and Agropur has not yet delivered
the milk or invoiced Walmart.

4. Walmart pays Agropur a $5,000 deposit for the order of the milk from part (3). Agropur has not
yet delivered the milk.

5. Agropur delivers the milk and bills Walmart for the remaining $25,000 they are owed. Walmart
has not yet paid the invoice.

6. Walmart calls Agropur one day after the delivery and reports that 3,000 liters of milk worth
$6,000 had spoiled sometime prior to its deliver. Walmart discards the 3,000 liters and Agropur
agrees to forgive the $6,000 receivable.

30
EXPENSE RECOGNITION

Given the revenue recognized in the period, expense recognition is reasonably straightforward. The
general goal is to get the expenses “matched” to the revenues that they helped generate (e.g., if sales
staff work for you during the period, their salary is an expense of the period regardless of when you pay
them because they were part of the cost of generating the revenue). Typically, you know that you have
an expense when an asset goes away (e.g., Cost of Goods Sold is recorded as an expense when you no
longer own the inventory) or a liability is taken on (salary expense is recorded when employees have
worked for you and you haven’t paid them yet). As with revenues, expenses eventually add up to cash
paid out, the only issue is timing. There are three possibilities in terms of timing:

Pay cash in the period the employees work for you:

Salary Expense (Income Statement) 100

Cash 100

Pay cash before they work for you:

Prepaid Salary (Asset) 100

Cash 100

Later when they work for you the asset goes away:

Salary Expense (Income Statement) 100

Prepaid Salary (Asset) 100

Pay cash after they work for you:

Salary Expense (Income Statement) 100

Salary Payable (Liability) 100

Later when you pay them:

Salary Payable 100

Cash 100

The important thing is that Salary Expense is recorded when they work regardless of when they are paid.

An Aside on Property, Plant and Equipment (PP&E)

Students often find PP&E accounting to be a little confusing, so it is worth laying it out in detail.
Conceptually, there are three things that happen to a piece of PP&E. The firm: (1) buys it, (2)
depreciates it over its useful life, and (3) eventually disposes of it. Imagine a typical piece of equipment.
Assume it costs $12,000, has an expected useful life of 10 years and an expected salvage of $2,000.9
Let’s think about each step separately in terms of the Balance Sheet and Income Statement.

9
We are implicitly assuming “straight-line” depreciation, which is the most common approach used for financial reporting in
the US. The underlying assumption is that assets are, on average, used up by an equal proportion each year of their life.
31
Purchase (year 0)

Let’s say we bought the equipment at the end of year zero. We would record the following (no effect on
the Income Statement):

Property, Plant and Equipment $12,000

Cash $12,000

Depreciation (years 1 through disposal)

Starting in year 1 (once we started using it), we would record depreciation. The best way to think about
depreciation is based on the Income Statement. It is an approach for spreading the expected loss in
value of an asset as an expense over its useful life. In other words, if part of the cost of doing business is
using up equipment, we want to reflect a portion of that cost every period in computing profitability.

If the piece of equipment had an original cost of $12,000 as noted previously, a 10 year expected useful
life and expected salvage value of $2,000 at the end of its life, we would expect it to lose ($12,000 -
$2,000) of value over its life or $10,000/10 years = $1,000/year. Therefore, we would record
depreciation expense of $1,000 per year.

Depreciation Expense (I/S) $1,000

Accumulated Depreciation (B/S-contra asset) $1,000

On the Balance Sheet, at the end of each year (recall that we bought on December 31, year 0):

Yr. 0 Yr. 1 … Yr. 6

Prop., Plant & Equip. (Cost) 12,000 12,000 12,000
- Accumulated Depreciation -0 - 1,000 - 6,000
Prop., Plant & Equip. (Net) 12,000 11,000 6,000

Accumulated depreciation is a “contra asset.” A contra asset is simply an account that reduces an asset
in a case in which we want to keep track of the pieces of the account separately. In this case we use a
contra asset because investors want to know not only the book value of the asset of $6,000 at the end of
year 6, but also the original cost of $12,000 and the fact that it has been depreciated by $6,000.10

On the Income Statement (and arbitrarily assuming Sales Revenue of $10,000 and Cost of Goods Sold
of $5,000 are the only other things on the Income Statement), every year the Equipment was used there
would be Depreciation Expense of $1,000:11

Other approaches are also permitted. More accelerated depreciation approaches are used for US tax purposes and frequently
outside the US for financial reporting purposes (i.e., proportionally more depreciation is taken early in the asset life).
10
That tells investors, for example, that the asset is about half way through its useful life (as opposed to being a new asset
that cost $6,000). If it was, say, prepaid rent of $12,000 that was half way used up, we typically wouldn’t use a contra asset
because investors don’t care about the pieces of prepaid rent.
11
As we will see later, the depreciation could be included in the line Cost of Goods Sold or Selling, General and
Administrative Expense depending on what the equipment was used for (e.g., manufacturing vs. corporate headquarters).
32
Income Statement

Sales Revenue $10,000

- Cost of Goods Sold -$5,000
- Depreciation Expense - 1,000
Net Income $4,000

Disposal (year 7)

The last step is the sale. Let’s assume we sell the piece of equipment at the beginning of year 7 (just
after year 6 depreciation has been recorded), for cash of $6,500. As noted above, the PP&E is on the
books with a cost of $12,000 and accumulated depreciation of $6,000. In terms of the t-accounts, the
beginning balance in PP&E (Cost) is $12,000 and in Accumulated Depreciation is $6,000:

When we sell, we need to clear out both the PP&E account (a credit of $12,000) and the Accumulated
Depreciation account (a debit of $6,000). Therefore, the sale journal entry has a credit to PP&E of
$12,000 for the cost and debit to Accumulated Depreciation for the depreciation accumulated through
the end of year 6. In addition, we have a debit to cash for the $6,500 received. That leaves a missing
credit of $500.

Prop., Plant & Equip. (Cost) Accumulated Depr.

BB = 12,000 BB = 6,000
Sale 12,000 Sale 6,000

End Bal. = 0 End. Bal. = 0

The important thing to note is that we sold something for $6,500 that was on the books for $6,000 (net
of accumulated depreciation). As a result, we have a gain of $500 on the sale. The journal entry is:

Cash 6,500
Accumulated Depreciation 6,000
Property, Plant & Equipment 12,000
Gain on Sale of Property, Plant and Equip. (I/S) 500

Note that the debit to Accumulated Depreciation is to clean out the Accumulated Depreciation account
in the same way that the credit to PP&E is to clean out the PP&E account. Some students are OK with
cleaning out PP&E, but struggle with the debit to Accumulated Depreciation. Both the credit to PP&E
and the debit to Accumulated Depreciation are simply to clean out the Balance Sheet accounts and
should be thought of together. In particular, do not think about the debit to Accumulated Depreciation
as negative depreciation expense (it does not affect the Income Statement). It is just housekeeping to
ensure that nothing remains on the Balance Sheet once the PP&E is sold. Once we are done with the
sale journal entry, the Balance Sheet will show zero for the cost of the equipment and zero for the
accumulated depreciation on it because we no longer own that asset.

Note also that we don’t split the sale of PP&E into Sales Revenue and Cost of Goods Sold. We
typically reserve those accounts for sales which are a primary part of the operations of the business (e.g.,
sales of inventory). Rather, the Gain typically appears further down the Income Statement among
“Other Gains” because it is viewed as a nonrecurring item.
33
Problem 3.3: Expense recognition problem

Stepanek Enterprises is a software company that specializes in filming and selling funny and
embarrassing videos of incidents involving MBA students. Fill in the attached table indicating when
Stepanek: (1) pays cash and (2) records expenses (June, July or August). What journal entries would
Stepanek record in June, July and August?

1) On July 1, pays $18,000 for one year’s rent on its new office. The lease begins on July 1 and
runs until June 30 of the following year. (I don’t care if you combine entries within a month).

2) On July 2, receives a utility bill totaling $200 for regular services received during June. Pays
the utility bill during July. Stepanek was able to estimate the utilities used during June.

3) Purchases supplies on account costing $11,000 during June. Pays $5,000 for these purchases
during July and $6,000 during August. A count indicates that supplies on hand on May 31
totaled $2,000, on June 30 totaled $10,000, on July 31 totaled $7,000 and on August 31
totaled $3,000. There were no other purchases during the period. Stepanek estimates supplies
used during a month based on purchases and beginning and ending inventory counts.

34
 4) On July 7, pays $1,800 for advertisements that appeared in college magazines during June.

5) On July 18, pays $2,400 for a software license that will run for twelve months beginning on
August 1.

6) July 25: Pays $1,000 as an advance on the August salary of the founder, Michael Stepanek.

Transactions June July August

1 Cash
1 Expense
2 Cash
2 Expense
3 Cash
3 Expense
4 Cash
4 Expense
5 Cash
5 Expense
6 Cash
6 Expense
35
Problem 3.4 (extra problem)

Expense recognition: Carrefour is a French-based retailer chain that recognizes revenue at the time it
sells goods or renders services and reports in euros (€). Indicate the expense recognized during March (if
any) from each of the following hypothetical cash payments during March.

1. Pays €20,000 on March 4 for office supplies purchased during March. Office supplies on hand
on March 1 cost €5,000 and on March 31 cost €7,000. (Hint: You need to use purchases and
beginning and ending balances to compute supplies used during March).

2. Pays €100,000 on March 7 as a deposit on land Carrefour plans to purchase in April for a new
store.

3. Pays €400,000 on March 10 for advertising that appeared on French television during February.

4. Pays €1,200,000 on March 15 for refrigeration units delivered to its stores and put into use on
February 28. Carrefour expects refrigerators to last for five years and have no salvage value.

5. Pays €240,000 on March 20 for property taxes for the period from March 1 of this year to
February 28 of next year.

6. Pays €5,000 on March 25 for ordinary repairs made to a truck on March 1. The truck has a
remaining useful life of five years and the repairs do not change the useful life or functionality.
Under IFRS, repairs are only capitalized if they add to the functionality or expected life.

7. Pays €300,000 on March 31 in rent on a warehouse. The rental period covers March and April.

36
COMPLETING THE INCOME STATEMENT PROCESS

When we work a problem, you will be given last year’s Balance Sheet with blanks for the current year, a
blank Income Statement, t-accounts with the relevant account titles filled in and a list of transactions.
The basic steps I would follow to complete a problem are the following.

1. Fill in beginning balances for the Balance Sheet accounts based on the prior year balances.
Recall that asset accounts typically have debit balances and liability and equity accounts have
credit balances. Income Statement accounts have zero beginning balances since they are
temporary accounts.

2. Work the journal entries up to the income tax entry.

3. Post the journal entries to t-accounts, total the Income Statement t-accounts and fill in the
Income Statement up to the tax line (pretax income).

4. Compute tax expense based on pretax income, record the income tax expense entry, post it to the
t-accounts and complete the Income Statement.

5. Record and post the closing entry (or at least put Net Income into the Retained Earnings t-
account and zero out the Income Statement t-accounts).

6. Total the Balance Sheet t-accounts and complete the Balance Sheet.

37
Problem 3.5: Analysis of transactions and preparation of the Income Statement and Balance Sheet

This is a continuation of Problem 2.6 which covered transactions for KFBS as of November 30. KFBS
opened its first store on the 1st of December. The Balance Sheet for November is attached. Transactions
and events during December were as follows. Prepare (a) journal entries and t-accounts for the following
transactions, (b) an Income Statement for the month of December, and (c) a Balance Sheet as of the end
of December. Remember to carry forward balances for Balance Sheet accounts from November.

(1) During December: Sold apparel for $278,000 ($72,000 cash and $206,000 on account). The
original cost of the apparel to KFBS was $180,000.

(2) During December: Purchased apparel on account (accounts payable) totaling $242,000.

(3) December 1: Purchased inventory management and anti-theft equipment for the shopping
floors for $120,000. The firm financed the amount with a note payable from a local bank at
an interest rate of 10% each year.

(4) During December: Collected $94,000 from customers for apparel sold in part (1).

(5) During December: Paid $36,000 in compensation to employees for work done during
December.

(6) During December: Paid phone bills totaling $3,000 for phone service during December.

38
 (7) During December: Received an electricity bill of $500 for power used in December. KFBS
will pay the utility bill in January.

(8) During December: Paid invoices for $200,000 from apparel suppliers in time to receive a 2%
discount for prompt payment (i.e., paid $196,000 even though the original Inventory and
Accounts Payable had been set up for $200,000). KFBS also paid $40,000 to other suppliers
for which a discount was not available.

(9) December 31: KFBS owes employees salary of $4,000 for work that they did in the last week
of December to be paid on the next payday, January 7.

(10) December 31: KFBS depreciates equipment on a straight-line basis over the expected life and
uses an Accumulated Depreciation account. The equipment purchased for $120,000 in part
(3) has an expected useful life of five years and zero expected salvage value at the end of the
useful life.

(11) December 31: KFBS recognizes a portion of the prepaid rent paid for on November 1.
Recall that KFBS prepaid $50,000 for two months of rent running December 1-January 31.

(12) December 31: KFBS recognizes amortization on the trademark over 72 months. Recall that
KFBS purchased the trademark for $36,000 including the registration cost. For parsimony,
you may reduce the Trademark account directly rather than using an Accumulated
Amortization account for the trademark.

39
(13) December 31: KFBS recognizes a month’s worth of the prepaid insurance purchased in
November. Recall that KFBS paid $12,000 for a year’s worth of insurance beginning on
December 1.

(14) December 31: KFBS pays interest for December on the loan taken from the bank on
December 1 in part (3). The loan was for $120,000 with a 10% annual interest rate.

(15) December 31: KFBS owes income taxes at 30% of pretax income. Taxes are paid on January
15 for taxes due on pretax income for the previous quarter.

40
 Cash Accounts Receivable Inventory

Prepaid Rent and Insurance

Equipment Accumulated Depreciation Trademark, net

Accounts Payable Utilities Payable Compensation payable

Income Taxes Payable Note Payable

Contributed Capital Retained Earnings

41
 Sales Revenue Cost of Goods Sold Compensation Expense

Phone & Utility Expense Depreciation & Amort. Expense Rent Expense

Insurance Expense Interest Expense Income Tax Expense

42
KFBS Group Balance Sheet
ASSETS Nov. 30 Dec. 31
Cash $206.0
Accounts Receivable 0.0
Inventory 276.0
Prepaid Rent and Insurance 62.0
Total Current Assets 544.0

Equipment 0.0
Less: Accumulated Depreciation 0.0
Equipment, net 0.0
Trademark, net 36.0
Total Noncurrent Assets 36.0
TOTAL ASSETS $580.0

LIABILIITES AND EQUITY

Accounts Payable $80.0
Utilities Payable 0.0
Compensation Payable 0.0
Income Taxes Payable 0.0
Total Current Liabilities 80.0

Notes Payable 0.0

TOTAL LIABILITIES 80.0

Contributed Capital 500.0

Retained Earnings 0.0
TOTAL EQUITY 500.0
TOTAL LIABILITIES AND EQUITY $580.0
43
KFBS Group Income Statement
Dec. 31
Revenues
Cost of sales
Gross margin
Compensation Expense
Phone & Utility Expense
Depreciation & Amort. Expense
Rent Expense
Insurance Expense
Profit from operations
Interest expense
Income before taxes
Income taxes
Net income

44
Problem 3.6: Analysis of transactions and preparation of the Income Statement and Balance Sheet

Preparation of income statement and balance sheet. The following transactions relate to Staats
Group, a book retailer, in 2020. All numbers are in millions of dollars. Do not worry if accounts
temporarily have negative balances—the transactions are not always sequential. It is fine to record
adjusting entries during (rather than at the end) of 2020.
.
(1) March 15, 2020: Pays income taxes of $1.4 due from 2019. Staats records income taxes owed (tax
payable) at the end of a given year and pays them in March of the following year.

(2) June 30, 2020: Repays the note payable of $30.0 with interest. Staats originally borrowed $30.0 on
June 30, 2019 with an interest rate of 6% per year. Note that Staats had accrued interest payable of $0.9
as of the end of 2019.

(3) July 1, 2020: Obtains a new bank loan (note payable) for $75.0. The loan is repayable on June 30,
2021, with interest due at maturity of 8%.

(4) July 1, 2020: Pays the rent of $20.0 for the period July 1, 2020 to June 30, 2021. Staats always pays
the rent for a year in advance. The previous rent payment of $20.0 was made on July 1, 2019 for the
period July 1, 2019 to June 30, 2020 (i.e., you will also need to account for the expiration of the
previous prepaid rent).

(5) During 2020: Purchases books costing $310.0. Of the total, $302.0 is on account payable and $8.0
relates to a deposit paid to a supplier in 2019 for special books to be delivered in 2020.

45
(6) During 2020: Returns damaged books costing $22.7. Staats had not yet paid for these books.

(7) During 2020: Sells books for $353.7. Of the total, $24.9 is for cash, $1.0 is for special orders
(advances from customers) cash received during 2019, and $327.8 is on accounts receivable. Don’t
worry about Cost of Goods Sold at this point—you will solve for it in Part 15 below.

(8) During 2020: Collects from customers. The ending balance in accounts receivable at year-end 2020
is $13.0 (you need to compute how much was collected).

(9) During 2020: Pays employees compensation of $29.4 for work performed during 2020.

(10) During 2020: Pays suppliers $281.1 for purchases of books on account.

(11) Dec. 31, 2020: Declares and pays a dividend of $4.0.

46
Adjusting Entries: Dec. 31, 2020

(12) Record depreciation on equipment purchased in 2019: (1) bookshelves which cost $4.0, with a 5-
year lie and no salvage, and (2) computers which cost $10.0 with a 3-year life and $1.0 salvage.

(13) Accrue interest on the note payable in part (5): $75.0 loan, 8% annual interest, borrowed on July 1,
2020, payment of interest and principal due on July 1, 2021.

(14) Record the expiration of prepaid rent from part (4): $20.00 for a year, paid in advance on July 1,
2020.

(15) Calculate cost of goods sold. A count indicates an ending balance in inventory of $12.6.

(16) Compute and record tax expense. Taxes will be paid in 2021 and are computed as 40% of Income
before Taxes.

47
 Cash Accounts Receivable Inventory

Prepaid Rent Deposit with Supplier

Equipment Accumulated Depreciation

Accounts Payable Notes Payable Advances from Customers

Interest Payable Income Tax Payable

Contributed Capital Retained Earnings

48
 Sales Revenue Cost of Goods Sold Compensation Expense

Depreciation Expense Rent Expense

Interest Expense Income Tax Expense

Staats Group Income Statement

Dec-19 Dec-20
Sales Revenue $172.8
Cost of Goods Sold (139.8)
Gross Margin 33.0
Compensation Expense (16.7)
Depreciation Expense (1.9)
Rent Expense (10.0)
Profit from Operations 4.4
Interest Expense (0.9)
Income before Taxes 3.5
Income Tax Expense (1.4)
Net income $2.1

49
Staats Group Balance Sheet
ASSETS Dec-19 Dec-20
Cash $24.7
Accounts Receivable 5.8
Inventory 5.4
Prepaid Rent 10.0
Deposit with Supplier 8.0
Total Current Assets 53.9

Equipment 14.0
Less: Accumulated Depreciation (1.9)
Equipment, net 12.1
TOTAL ASSETS $66.0

LIABILIITES AND EQUITY

Accounts Payable $5.6
Notes Payable 30.0
Advances from Customers 1.0
Interest Payable 0.9
Income Tax Payable 1.4
Total Current Liabilities 38.9
TOTAL LIABILITIES 38.9

Contributed Capital 25.0

Retained Earnings 2.1
TOTAL EQUITY 27.1
TOTAL LIABILITIES AND EQUITY $66.0
50
 CHAPTER 4: STATEMENT OF CASH FLOWS

As noted earlier, the Statement of Cash Flows explains the change in cash during the period in terms of
Cash from Operations, Cash from Investing and Cash from Financing. Conceptually, the statement is
straightforward. If you list all of the cash flows during the period, you end up with the change in cash on
the Balance Sheet. In practice, it is a little more complicated than that, but it is not too bad. The good
news is that there are no new accounts for the Statement of Cash Flows. The bad news is that it can be a
little unintuitive initially. But, the other good news is that preparing a Statement of Cash Flows is very
“cookbook” in the sense that you can follow a set of steps and it will work.

The Statement of Cash Flows is quite young and, as a result, is more standardized than the other
statements. The Financial Accounting Standards Board (FASB) specifies what goes in each section. The
following table categorizes a typical set of cash inflows and outflows in terms of the corresponding
sections of the Statement of Cash Flows.

COMPONENTS OF THE STATEMENT OF CASH FLOWS

Cash Inflows Cash Outflows

Operating Section
Collect from customers Pay suppliers
Collect interest and dividends Pay interest
Other operating receipts Other operating payments
Pay taxes
Pay employees

Investing Section
Sell property, plant & equip. Purchase property, plant & equip.
Sell securities owned Purchase securities (or other companies)
Receive loan repayments Make loans (or buy bonds)

Financing Section
Borrow from creditors (or issue bonds) Repay amounts borrowed
Issue equity securities Repurchase stock
Pay dividends

51
FORMATS FOR THE STATEMENT OF CASH FLOWS

There are two formats for the operating section of the Statement of Cash Flows, the direct and indirect
methods. In both cases, the investing and financing sections are the same (only the operating section
changes).

The investing and financing sections simply list the sources and uses of cash (as we will see, this is
analogous to what the direct method does in the operating section):

Format for the Investing and Financing Sections:

Cash From Investing
- Investments in Securities
+ Proceeds from Sales of Securities
- Investments in Property, Plant & Equipment
+ Proceeds from Property, Plant & Equipment
- Investments in Other Investing Assets
+ Proceeds from Sales of Other Investing Assets
Net Cash from Investing

Cash From Financing

+ Issuance of Long-Term Debt
- Repayments of Long-Term Debt
+ Issuance of Other Financing Debt
- Repayments of Other Financing Debt
+ Issuance of Common Stock
- Dividends Paid
- Repurchase of Common Stock
Net Cash from Financing

DIRECT METHOD

The direct method for the operating section looks a lot like the investing and financing sections; it just
lists all of the sources and uses of operating cash flows. That is why it is called “direct.” The direct
method is rare in practice because it requires something like temporary accounts to keep track of where
the cash flows came from and went. As a result, we won’t spend much time on the direct method.

Cash From Operations

Cash Inflows
+ Collections from Customers
+ Interest and Dividends Received
+ Other Operating Receipts
Cash Outflows
- Payments to Suppliers
- Payments to Employees
- Interest Paid
- Taxes Paid
- Other Operating Cash Payments
Net Cash from Operations
52
INDIRECT METHOD

The indirect method is very common in practice. It takes a fundamentally different tack in that it doesn’t
list the cash flows directly but, instead, starts with Net Income and ends up with Change in Cash. In
other words, it is really more of a reconciliation explaining why Net Income was not equal to Change in
Cash. On the surface it seems a little weird, but the way to think about it is that the investor has already
seen the Balance Sheet and Income Statement and knows the bottom line Change in Cash as well as Net
Income, and is wondering why Net Income is not equal to Change in Cash. Cash from Investing and
Financing are the same as under the direct method, so the only issue is with Cash from Operations.

To understand the intuition behind the indirect method, it is useful to think about how you might go
about starting with Net Income and ending up with Change in Cash. One approach would be to use the
algebra of the Balance Sheet:

Assets = Liabilities + Owners’ Equity

Splitting Assets into Cash and Noncash, and Owners’ Equity into Contributed Capital and Retained
Earnings,

Cash + Noncash Assets = Liabilities + Contributed Capital + Retained Earnings

Taking changes ( denotes a change) and moving Noncash Assets to the other side of the equality,

Cash = Liabilities + Contributed Capital + Retained Earnings - Noncash Assets

Recognizing that:

Retained Earnings = Net Income – Dividends,

leaves (after moving Net Income to the front of right hand side of the equation),

Cash = Net Income + Liabilities + Contributed Capital – Noncash Assets – Dividends

In other words, if you wanted to start with Net Income and end up with Change in Cash, one approach
would be to adjust for dividends and the changes in liabilities, contributed capital and noncash assets.
The algebra is not really important, other than to convince you that it works if you include all the bits
and get the signs right. However, there is also important intuition here, and it helps to understand why
the indirect method is useful.

53
Suppose, for example, that a firm was profitable during the period, but its cash balance dropped. How
could that happen? It has to be one or more of the following given the preceding equation:

Cash = Net Income + Liabilities + Contributed Capital – Noncash Assets – Dividends

1. They paid off liabilities (Liabilities is negative). That would reduce cash, but not affect Net
Income.
2. They repurchased shares (Contributed Capital is negative). Don’t worry about why firms
repurchase shares for the moment, but realize that repurchasing shares (buying out
shareholders) reduces contributed capital and cash but does not affect Net Income.
3. They purchased more assets such as inventory and PP&E (Noncash Assets is positive). That
would reduce cash but not Net Income (and is a big reason why profitable growing
companies can run out of cash).
4. They paid a dividend. That doesn’t affect Net Income (dividends are not an expense) but it
does reduce cash.

That’s the idea. In practice, it is easy because we will fill out a standardized form (some lines may be
blank or need to be tweaked, but we will start with the form). If all the lines on the Balance Sheet are
accounted for and the signs are consistent with the equation, then it has to add up to Change in Cash:12

Cash = NI + Liabilities + Contributed Capital – Noncash Assets – Dividends

12
It is important to follow the signs in the equation because terminology on the form can sometimes be confusing. For
example, the form lists, “- Investments in Property, Plant and Equipment,” which makes sense because buying PP&E is a use
of cash and it is consistent with the formula because investing in PPE increases PP&E and the formula lists “– Noncash
Assets.”

54
Where Does Everything Go?

The following worksheet illustrates where the changes go and the signs. In practice we won’t use this
worksheet very often because we will use a standardized form, but it illustrates the concepts.

Changes in Assets Operating Investing Financing

(1) Accounts Receivable x(-)
(2) Inventories x(-)
(3) Other Current Assets (Usually)1 x(-)
2
(4) Investments in Securities x(-)
Property, Plant & Equipment
(5) Cost3 (Purchases) x(-)
(6) Acc. Depr.3 (Current Yr’s Depr.) x(+)
1
(7) Other Noncurrent Assets (Usually) x(-)
Changes in Liabilities
(8) Accounts Payable x(+)
2
(9) Notes Payable x(+)
(10) Current Portion of Long-Term Debt4 x(+)
(11) Other Current Liabilities (Usually)1 x(+)
(12) Long-Term Debt2 x(+)
(13) Deferred income Taxes x(+)
(14) Other Noncurrent Liabilities (Usually)1 x(+)
Changes in Equity
(15) Contributed Capital x(+)
(16) Retained Earnings x(Net Inc)(+) x(Div.)(-)
(17) Treasury Stock (Repurchased Shares) __________ _________ x(-)
(18) Cash
1
You will be told what sections these fall under when we work specific problems.
2
Increases and decreases are generally disclosed separately.
3
For sales of PP&E (or other investments), profits are subtracted from Net Income in the operating section and the entire
proceeds are included as a source of cash in the investing section (more on that later).
4
Generally combined with long-term debt.

55
Here is the standard form we will be using in all of the Statement of Cash Flows problems. Since it is
standardized, lines will sometimes be left blank or have to be tweaked to fit a specific problem.

Standard Indirect Format Worksheet

Cash From Operations

Net Income
+ Depreciation
- Gain on Sale of Property, Plant & Equipment
- Increase in Accounts Receivable
- Increase in Inventory
- Increase in Other Operating Assets
+ Increase in Accounts Payable
+ Increase in Other Operating Liabilities
+ Increase in Deferred Income Taxes
Net Cash From Operations

Cash From Investing

- Investments in Securities
+ Proceeds from Sales of Securities
- Investments in Property, Plant & Equipment
+ Proceeds from Property, Plant & Equipment
- Investments in Other Investing Assets
+ Proceeds from Sales of Other Investing Assets
Net Cash from Investing

Cash From Financing

+ Issuance of Long-Term Debt
- Repayments of Long-Term Debt
+ Issuance of Other Financing Debt
- Repayments of Other Financing Debt
+ Issuance of Common Stock
- Dividends Paid
- Repurchase of Common Stock
Net Cash from Financing

Net Change in Cash

56
Problem 4.1: Statement of Cash Flows from changes in Balance Sheet with no sales of PP&E

MIFY (Move It For You) is a global shipping company headquartered in Austin, TX. MIFY has its own
fleet of ships, planes and trucks. The changes in the Balance Sheets of MIFY for the last year are shown
below (amounts in thousands):

Change Amount Direction

Cash $ 38.9 Inc
Property, Plant, and Equipment (at cost) $ 1,134.6 Inc
Accumulated Depreciation $ 255.4 Inc
Inventories $ 17.2 Inc
Accounts Receivable $ 14.7 Dec
Prepaid Advertising $ 16.2 Inc
Other Noncurrent Investing Assets $ 6.6 Inc
Long-Term Debt $ 266.4 Inc
Other Current Operating Liabilities $ 126.6 Inc
Other Noncurrent Financing Liabilities $ 274.7 Inc
Accounts Payable $ 0.5 Dec
Common Stock $ 100.3 Inc
Retained Earnings $ 175.9 Inc

Assume there are no sales of property, plant and equipment and no dividends. Prepare a Statement of
Cash Flows on the attached form.

57
Problem 4.2 (extra problem): Statement of Cash Flows from changes in Balance Sheet with no
sales of PP&E

Southwest Airlines
Change
Cash + 40

Accounts Receivable - 15
Inventories + 15
Prepayments + 17
Property, Plant and Equipment + 1,135
Accumulated Depreciation + 264
Other Noncurrent (Inv.) Assets +9

Accounts Payable -1
Other Current (Oper.) Liabilities + 115
Long-Term Debt + 244
Other Noncurrent (Fin.) Liabilities + 140
Common Stock + 97
Retained Earnings + 341

Note: Net income was $474. Southwest did not sell any Property, Plant & Equipment.

58
Standard Indirect Format Worksheet

Cash From Operations

Net Income
+ Depreciation
- Gain on Sale of Property, Plant & Equipment
- Increase in Accounts Receivable
- Increase in Inventory
- Increase in Other Operating Assets
+ Increase in Accounts Payable
+ Increase in Other Operating Liabilities
+ Increase in Deferred Income Taxes
Net Cash From Operations

Cash From Investing

- Investments in Securities
+ Proceeds from Sales of Securities
- Investments in Property, Plant & Equipment
+ Proceeds from Property, Plant & Equipment
- Investments in Other Investing Assets
+ Proceeds from Sales of Other Investing Assets
Net Cash from Investing

Cash From Financing

+ Issuance of Long-Term Debt
- Repayments of Long-Term Debt
+ Issuance of Other Financing Debt
- Repayments of Other Financing Debt
+ Issuance of Common Stock
- Dividends Paid
- Repurchase of Common Stock
Net Cash from Financing

Net Change in Cash

59
AN ASIDE ON PROPERTY, PLANT AND EQUIPMENT

In the preceding problem, we assumed there were no sales of Property, Plant and Equipment (PP&E). In
the more general case, there will be sales of PP&E which complicate things a little. However, once we
cover sales of PP&E, that is as complicated as it gets (for us).

Conceptually, there are three things that happen to a piece of PP&E. The firm: (1) buys it, (2)
depreciates it over its useful life, and (3) eventually disposes of it. Consider the piece of equipment that
we discussed in the previous chapter with respect to depreciation. The equipment cost $12,000, had an
expected useful life of 10 years and an expected salvage of $2,000. Let’s review each step in terms of
the Balance Sheet and Income Statement, and then the Statement of Cash Flows.

Purchase (year 0)

When we bought the equipment at the end of year zero, we recorded the following:

Property, Plant and Equipment $12,000

Cash $12,000

Depreciation (years 1 through disposal)

Starting in year 1 we recorded depreciation.

Depreciation Expense (I/S) $1,000

Accumulated Depreciation (B/S-contra Asset) $1,000

Disposal (year 7)

When we sold the piece of equipment at the beginning of year 7, we recorded the following. Recall that
we needed to clean out the historical cost ($12,000) and the accumulated depreciation (6 years x $1,000
= $6,000) from the Balance Sheet. The net book value of the asset was the cost less the accumulated
depreciation ($12,000 - $6,000 = $6,000) so, if we sold it for $6,500, we had a gain on sale of $500.

Cash 6,500
Accumulated Depreciation 6,000
Property, Plant & Equipment 12,000
Gain on Sale of Property, Plant and Equip. (I/S) 500

60
EFFECT OF PP&E ON THE STATEMENT OF CASH FLOWS

What about the Statement of Cash Flows?

Purchase

The purchase is easy. On the Statement of Cash Flows, there is simply a cash outflow in the investing
section.

Cash from Investing

- Investments in Property, Plant & Equip. -$12,000

Depreciation and Gain on Sale

To understand the implications of depreciation and the sale of PP&E for the Statement of Cash Flows,
let’s start with the implications for the Income Statement.13 To make it more concrete, let’s (arbitrarily)
assume Sales Revenue of $10,000 and Cost of Goods Sold of $5,000:

Sales Revenue $10,000

- Cost of Goods Sold - 5,000
- Depreciation - 1,000
+ Gain on Sale of PP&E + 500
Net Income $4,500

The Statement of Cash Flows starts with Net Income. Note that, with no adjustments, we would end up
with Cash from Operations of $4,500. But, we have to ask ourselves two questions, one on Depreciation
and the other on the Gain on Sale of PP&E.

First, did depreciation expense involved a use of cash (remember we are adjusting for items that are on
the Income Statement but do not belong in Cash from Operations)? The answer is “No”. Depreciation
expense is a “noncash charge,” so we need to undo the effect from the Income Statement to get closer to
a cash basis. That means adding back depreciation. It may seem weird to add back depreciation since it
is an expense, but that is exactly the point. It was subtracted on the Income Statement and, to get closer
to a cash basis, we need to undo that by adding it back (depreciation is not a source or use of cash).

Second, does the Gain on Sale of PP&E belong in Cash from Operations? Again, the answer is “No”.
Sales of PP&E are fundamentally about investing, not operations. However, because the gain is part of
Net Income, if we didn’t adjust it out, it would end up in Cash from Operations. Therefore, we undo it
by subtracting it out in the operating section. Assuming nothing else needs to be adjusted:

Cash from Operations

Net Income $4,500
+ Depreciation + 1,000
- Gain on Sale of PP&E - 500
Cash from Operations $5,000

13
I’m being a little sloppy here because I have the purchase, sale and depreciation all taking place in the same period. Think
of it, not as one machine, but as many similar machines. Some new ones are being purchased for $12,000, some that are in
use are being depreciated for $1,000 and some old ones are being sold for $6,500.
61
Then, in the Cash from Investing Section, we add the cash from selling the PP&E.14 Combined with the
purchase of PP&E noted above, we have:15

Cash from Investing

- Investments in PP&E - $12,000
+ Proceeds for Sales of PP&E + 6,500
Cash from Investing - $5,500

14
Another way to think about it is that Proceeds from Sales of PP&E ($6,500) includes the $500 gain; we need to subtract it
out from the operating section so we don’t double count it.
15
For those who like completeness, note the following. Earlier we said that we have to take into account all changes in
Balance Sheet accounts on the Statement of Cash Flows and that changes in asset accounts get subtracted. Note that, in this
case, net PP&E went up by $5,000 (we purchased $12,000, sold book value of $6,000 and depreciated existing PP&E by
$1,000). Therefore, -$5,000 should appear somewhere on the Statement of Cash Flows. Instead, we added back depreciation
(+$1,000), subtracted the gain (-$500), subtracted the new investment (-$12,000) and added the proceeds from sale
(+$6,500). That adds to -$5,000, which is exactly what we need to explain the change in PP&E. Bottom line, if you add
back Depreciation, subtract the Gain on Sale, subtract the new Investment in PP&E and add the Proceeds from Sales of
PP&E, it will always add to the right number to make the Statement of Cash Flows work.
62
Steps for preparing the Statement of Cash Flows (including sales of PP&E). From beginning to
end, this example shows all the steps for preparing a Statement of Cash Flows:

1. Compute changes in each Balance Sheet account.

1/1 12/31 Chg.

Cash 52 58 6
Accounts Receivable 93 106 13
Inventory 151 162 11
Land 30 30 0
Buildings and Equipment 790 830 40
Accumulated Depreciation 460 504 44

Accounts Payable 136 141 5

Interest Payable 10 8 -2
Mortgage Payable 120 109 -11
Contributed Capital 250 250 0
Retained Earnings 140 174 34

Other: Net income = 44, Dividends = 10, Depreciation Expense = 54.

Sold for 5 of machinery originally costing 15 with accumulated depreciation of 10 (no gain/loss).
Purchased building and equipment for 55.

2. Fill in the indirect format worksheet for each of the changes other than PP&E and accumulated
depreciation (we will handle PP&E last because it is the tricky bit). Use the Balance Sheet Accounts
on the Statement of Cash Flows worksheet on page 44 if you don’t know where something goes.
Check to make sure you have picked up each account. I have filled in the numbers for this step in
italics in the SCF below. You should have blanks on the SCF for “Investments in PP&E,” “Proceeds
from Sale of PP&E,” “Depreciation” and “Gain on Sale of PP&E.”

3. Recreate the PP&E journal entries for the purchase of PP&E, depreciation for the period and
dispositions of PP&E, and fill in the four circled numbers in the corresponding spaces:

Buildings and Equipment 55

Cash 55

Depreciation Expense 54
Accumulated Depreciation 54

Cash (proceeds from sale) 5

Accumulated Depreciation (Accumulated Depr. on assets sold) 10
Property, Plant and Equipment (historical cost of assets sold) 15
Gain on Sale of PP&E (Proceeds – BV, zero in this case) 0

Note that the Depreciation add-back (+$54 in CFO), the subtraction of the Gain (-$0 in CFO), the
subtraction of the Investment in PPE (-$55 in CFI) and the addition of Proceeds from Sales of PP&E
(+$5 in CFI) all adds to +$4. Note also that PP&E, net, went down by $4 (Cost of PP&E increased by
$40 and Accumulated Depreciation increased by $44), so we are consistent with the SCF equation.

63
Indirect Format

Cash From Operations

Net Income 44
+ Depreciation + 54
- Gain on Sale of PP&E (or other investments) -0
- Increase in Accounts Receivable - 13
- Increase in Inventories - 11
- Increase in Other Current Assets 0
+ Increase in Accounts Payable + 5
+ Increase in Other Current Liabilities -2
+ Increase in Deferred Income Taxes 0
Net Cash From Operations 77

Cash From Investing

- Investments in Securities 0
+ Proceeds from Sales of Securities 0
- Investments in Property, Plant and Equipment - 55
+ Proceeds from Sales of Property, Plant and Equipment +5
- Investments in Other Noncurrent Assets 0
+ Proceeds from Sales of Other Noncurrent Assets 0
Net Cash from Investing

Cash From Financing

+ Issuance of Notes Payable 0
- Repayments of Notes Payable 0
+ Issuance of Long-Term Debt 0
- Repayments of Long-Term Debt -11
+ Issuance of Common Stock 0
- Dividends Paid - 10
- Repurchase of Common Stock 0
Net Cash from Financing - 21
Net Change in Cash 6

64
Problem 4.3: Preparing a Statement of Cash Flows

Condensed financial statement data for the Heisenberg Crystal Company for the current year are below.
During the current year, the firm sold for cash of $6.0 equipment that originally cost $15.0 with $10.0 of
accumulated depreciation. Dividends paid were $10.0. All amounts are in thousands. (Hint: You are
going to need to use information in the problem to compute Net Income, investments in PP&E during
the year and depreciation expense for the year.)

BALANCE SHEET Jan. 1 Dec. 31 Change

ASSETS
Cash $57.2 $63.8 6.6
Accounts Receivable 102.3 116.6 14.3
Inventory 166.1 178.2 12.1
Total Current Assets 325.6 358.6

Property, Plant and Equipment 902.0 946.0 44.0

less: Accumulated Depr. -506.0 -554.4 -48.4
Property, Plant and Equip. (net) 396.0 391.6

TOTAL ASSETS $721.6 $750.2

LIABILITIES AND EQUITY

Accounts Payable $149.6 $155.1 5.5
Interest Payable 11.0 8.8 -2.2
Long Term Debt 132.0 119.9 -12.1
TOTAL LIABILITIES 292.6 283.8

Contributed Capital 275.0 275.0 0.0

Retained Earnnings 154.0 191.4 37.4
TOTAL EQUITY 429.0 466.4
TOTAL LIABILITIES AND EQUITY $721.6 $750.2

65
Problem 4.4 (extra problem): Preparing a Statement of Cash Flows

Green Mountain Coffee

Change
Cash + 74

Accounts Receivable + 2,231

Inventories - 59
Prepayments - 475
Property Plant and Equipment + 2,129
Accumulated Depreciation + 1,038
Other Noncurrent (Oper.) Assets + 434

Accounts Payable + 1,574

Other Current (Oper.) Liabilities + 560
Bonds Payable + 2,827
Common Stock - 5,878
Retained Earnings + 4,213

Note: No dividends, sold equipment for $538 that initially cost $2,468 with accumulated depreciation of
$1,930. Purchased equipment for $4,597. Recorded depreciation of $2,968.

66
Indirect Format Worksheet

Cash From Operations

Net Income
+ Depreciation
- Gain on Sale of PP&E
- Increase in Accounts Receivable
- Increase in Inventory
- Increase in Other Current Assets
+ Increase in Accounts Payable
+ Increase in Other Current Liab.
+ Increase in Def. Income Taxes
Net Cash From Operations

Cash From Investing

- Investments in Securities
+ Proceeds from Sales of Sec.
- Investments in PP&E
+ Proceeds from Sales of PP&E
- Invest. in Other NC Assets
+ Proceeds from Other NC Assets
Net Cash from Investing

Cash From Financing

+ Issuance of Notes Payable
- Repayments of Notes Payable
+ Issuance of Long-Term Debt
- Repayments of Long-Term Debt
+ Issuance of Common Stock
- Dividends Paid
- Repurchase of Common Stock
Net Cash from Financing

Net Change in Cash

67
 CHAPTER 5: RATIOS

Suppose that, in a given year, Coke reports $10 million in Net Income. Is that a good result? To answer
that question our brains naturally revert to “compared to what?” A number like $10 million is difficult
to evaluate without context. That is what ratios are designed to do—provide context to a number by
dividing it by another number.16 There are at least two basic points to bear in mind with ratios.

1. There are no “right” ratios. Whatever provides intuition in a setting is a good ratio. That being
said, we will be covering some common ratios that provide intuition.
2. Ratios generally don’t answer questions; they just frame them. I can use ratios to structure my
thinking about what is causing changes in Coke’s profitability, potential directions they might
take and trade-offs, but I can’t use ratios to definitively identify what direction Coke should take.

In class, we will consider three primary questions using ratios.

1. Would $10 billion of Net Income be a good result for Coke and how could it be improved?
2. Is Coke likely to go bankrupt?
3. Is Coke a good buy at $45/share? This question will transition us into valuation.

Here we will focus on the first question because the ratios for the other two are pretty straightforward.

The $10 Billion Question: ROA and ROE

If Coke earns $10 billion in Net Income in a given year, is that a good result? More generally, how can
we use ratios to contextualize a Net Income result?

A simple example will help to illustrate several of the issues we will be considering and, in particular,
the effect of financing. Imagine two firms, with the following summary Balance Sheets and Income
Statements (for parsimony, I am assuming that the two firms’ Balance Sheets are constant over time so
that, for example, average assets over the year are $1,000). Assume that both firms have identical assets
and use those assets identically (i.e., their operations and investment decisions are the same). As a
result, their Total Assets and Operating Income are the same. The only difference is in their financing
choices. Company A has chosen to have no debt in their capital structure (all equity), while Company B
is financed $800 with equity and $200 with debt.

16
As an aside, $10 million would be a horrible result because Coke normally earns about $10 billion, but that is the point. It
is difficult to interpret a large number without context.
68
EXHIBIT I: SIMPLE EXAMPLE
Co. A Co. B
Assets $1,000 $1,000
Liabilities 0 200
Equity $1,000 $800

Sales $800 $800

- Operating expenses -700 -700
Operating Income 100 100
Interest expense 0 -10
Net Income before taxes 100 90
Income tax expense (30% rate) 30 27
Net income $70 $63

How did Company A perform relative to Company B? Net Income, in and of itself. is not particularly
informative. It depends on, among other things, how much the two companies have tied up in terms of
resources. A typical approach is to compute a measure of a return by dividing a measure of profitability
by some measure of resources tied up. The specific measure of profitability in the numerator and of
resources in the denominator depend on the question being asked and, in particular, whether we want the
measure to be affected by financing choices.

We will consider two common denominators: Total Assets (Return on Assets or ROA) and Total Equity
(Return on Equity or ROE). We want to be careful in choosing our denominator to ensure that it makes
sense given the question we want to ask and, in particular, whether we want to include the effects of
financing. Also, we want to be sure that our numerator is conceptually consistent with the denominator.

Return on Assets

While financing is ultimately important, it is often easier to start with an analysis before financing (just
operating and investing) and then layer in financing later. There are at least two reasons that makes
sense. First, conceptually, financing choices can be separated from operating and investing (i.e., there
are a variety of ways to finance the same operating and investing activities). Second, the operating and
investing activities are complicated enough to understand without layering on the added (and separable)
complexity of financing. Therefore, our first measure, Return on Assets (ROA), will be computed
before the effects of financing.

The issue is how to recast Co. B’s financial statements to reflect how they would have appeared had
there been no debt in the capital structure. Note that the simple example above is constructed explicitly
to illustrate the effects of debt financing on the financial statements. In other words, Co. B would have
looked exactly like Co. A absent debt. How would we adjust Co. B’s profitability to remove the effects
of financing? We would need to add back $7 to Co. B’s profits. Why $7 (as opposed to $10)? Note
that debt has two effects on profitability. First, interest expense reduces pretax profit by $10. Second,
because interest is tax deductible, taxes are reduced. The tax rate is 30% in this case, so the tax effect is

69
($10 x 30%) = $3.17 The two effects net to a reduction of profitability for Co. B of $7 as a result of
having debt in the capital structure (pretax income is lower by $10 and taxes are lower by $3).

Therefore, the numerator in ROA will be: (Net Income + ((1 – Tax Rate) x Interest Expense))
How about the denominator? Had Company B had no debt, its Balance Sheet would look just like
Company A. In other words, the resources tied up before financing are the Total Assets.

Note one other important point. Whenever we divide an Income Statement item by a Balance Sheet
item, we will use the average of the Balance Sheet item. The Income Statement is measured over the
year so, for consistency, we will compare the Income Statement item to the average of the Balance Sheet
item over the course of a year.18 In other words, with ROA we want to hold management responsible
for how much they earned during the year relative to the average assets at their disposal during the year.

The bottom line is that we will define ROA as

ROA ≡ (Net Income + ((1 – Tax Rate) x Interest Expense))/Average Total Assets

As a result,

ROA (Co. A) = $70/$1,000 = 7%

ROA (Co. B) = ($63 + ((1 – 30%) x $10))/$1,000 = ($63 + $7)/$1,000 = 7%.

Note a few things. First, both companies had identical ROA and, therefore, their performance was
identical before the effects of financing (only taking into account operations and investing). When
comparing Coke and Pepsi in class, we will start with ROA (before financing) and that will permit us to
examine how well Coke and Pepsi performed abstracting from financing differences. Second, this is the
approach that you might take to compensate a manager who does not control financing decisions (just
operating and investing decisions). Third, while it might seem tempting to just use Net Income in the
numerator of ROA (and some people do for simplicity), ignoring the interest add-back will always give
you the answer that debt is bad (Company B would look worse than company A simply because it had
debt in the capital structure). Given virtually all companies choose to have debt in their capital
structure, debt must have an upside (and we will see what it is when we move to Return on Equity).

Disaggregation

What is wrong with the preceding? It is really too aggregated to say much more. To proceed, we will
decompose ROA into components. Going forward, I will refer to interest-adjusted Net Income (ANI):

ANI ≡ Net Income + (Interest Expense x (1 - Tax Rate))

Note the following algebra:

17
As an aside, this is an important concept going forward (both in this class and in others). Most corporate expenses are tax
deductible which means that, assuming a 30% tax rate, any expense of the corporation only reduces profits by 70% of the
gross amount (the other 30% is borne by the government).
18
For convenience, we will generally compute the average as: (Beginning of the year balance + End of the year balance)/2.
Technically, using the four quarters divided by four would give a slightly more accurate answer. For parsimony, in this
example, we will assume that the Balance Sheet remains constant.

70
ROA = ANI/Average Total Assets = (ANI/Sales) x (Sales /Average Total Assets)

Algebraically, there is nothing special about Sales here; anything would have worked as long as it was
consistent in the numerator and denominator. Why Sales then? Because Sales provides intuition. The
first term, (ANI/Sales), captures pre-financing profitability per dollar of sales and is a measure of profit
margin. The second term, (Sales/Ave. Total Assets), captures dollars of sales per dollar of assets and is
a measure of “turnover” or efficiency. Walmart, for example, has very low profit margins per dollar of
sales but “makes it up on the volume,” with high sales per dollar of assets. A firm can have high ROA
either because it has high profit margins or because it has high volumes, but it is difficult to do both at
the same time because firms with high profit margins typically have low volumes (Prada stores have
high profit margins but there is low volume per dollar of assets tied up). In class we will do more with
examples from actual companies. The punchline though is that, as a manager, if you want to improve
ROA, you either work on profit margins (Prada), turnover (Walmart) or try to pick a spot in the middle
(Macy’s).

Going back to our example,

ROA (Co. A) = $70/$1,000 = 7%

= $70/$800 x $800/$1,000 = 8.75% x 0.8 = 7%

ROA (Co. B) = ($63 + ((1 – 30%) x $10))/$1,000 = ($63 + $7)/$1,000 = 7%.

= $70/$800 x $800/$1,000 = 8.75% x 0.8 = 7%

In other words, both companies have the same ROA and the same components. Profit margin
(ANI/Sales) is the same for both firms (8.75%) and turnover (Sales/Ave. Total Assets) is the same for
both firms (0.8). In class, we will break the components down further (e.g., profit margins based on
Income Statement lines and turnover based on Balance Sheet lines), but the idea will be the same. We
will use the components to infer the effects and causes of differences in profit margins and efficiencies
on ROA for Coke and Pepsi.

Return on Equity

Going back to our example, we see that, after the effect of financing, Company B was less profitable
than Company A. In other words, debt in the capital structure lowers profitability because of the effect
of interest expense. That raises an important question. From the shareholders’ perspective, did
Company B make a mistake by having debt in its capital structure? It would be surprising if it did since
essentially all companies have debt in their capital structures. The answer is subtler than that. Note that
it is definitely true that Company B is less profitable by virtue of the debt ($63 of Net Income versus $70
for Co. A). So, why take on debt?

Note the other effect of taking on debt. Company B tied up only $800 of shareholders’ equity to
generate its profit, while Company A tied up $1,000. In other words, having debt in the capital structure
has two effects, one bad and one good. The bad effect is that, all else equal, debt reduces profitability
available to shareholders because of interest expense on the debt. As a result, the size of the pie to be
shared among the shareholders is smaller. The good effect is that there are fewer shareholders among
whom to share the (reduced) profits since you have replaced some shareholders with debt financing.

71
ROE pulls all of that together. The numerator is now Net Income (i.e., after the effect of financing).
The denominator is Average Total Shareholders’ Equity (shareholder resources tied up after the effects
of financing).

ROE = Net Income/Average Shareholders’ Equity

Going back to our previous example,

ROE (Co. A) = $70/$1,000 = 7%

ROA (Co. B) = $63/$800 = 7.9%.

So, in Company B’s case, the overall effect of debt was to increase ROE. The effect on the numerator
(profitability) was more than offset by the effect on the denominator (average shareholders’ equity). To
see why that happened, notice that I assumed that the interest rate was 5% (Co. B paid $10 in interest on
$200 of debt). Company B earned 7% ROA on the money it borrowed for 5% or, in other words, it
earned more on the borrowed money than the cost of borrowing it and the rest went into the
shareholders’ pockets. When that happens, the shareholders are made better off by borrowing money.19

As a shareholder, I ultimately want to understand how well the company has done with my investment
(its shareholders’ equity), after the effect of financing (i.e., after the debt holders have gotten their
share). Similarly the CEO controls financing as well as operations and investing and should, therefore,
be held accountable for all three. Return on Equity (ROE) is designed to capture the profitability after
the effects of financing.

Again, we can decompose ROE into pieces (in this case three pieces).

ROE = NI/Ave. SH Equity = NI/Sales x Sales/Ave. Total Assets x Ave. Total Assets/Ave. SH Equity

ROE (Co. A) = $70/$800 x $800/$1,000 x $1,000/$1,000 = 8.75% x .8 x 1 = 7%

ROA (Co. B) = $63/$800 x $800/$1,000 x $1,000/$800= 7.9% x .8 x 1.25 = 7.9%

The first term, NI/Sales is, as before, a measure of profit margin (although not adjusted by adding back
interest in this case since ROE is after the effect of financing). The second term, Sales/Ave. Total
Assets, is identical to the second term for ROA, and is a measure of turnover or efficiency. The third
term, Ave. Total Assets/Ave. SH Equity, is new and captures the effect of “leverage” (debt in the capital
structure). It is the inverse of Ave. SH Equity/Ave. Total Assets, which measures the proportion of
assets financed with equity (as opposed to debt). In other words, for a given level of assets, the third
term will be higher the less equity (more debt) there is in the capital structure (i.e., the more highly
levered is the firm).

Overall, this suggests that there are three ways to improve ROE: (1) improve profit margins, (2) improve
turnover, or (3) take on debt and earn more on that money than the cost of borrowing it. Of course each
has its downsides. Raising prices reduces volumes. Raising volumes often reduces the price you can
charge (people who pay a premium expect pleasant spacious stores and well-stocked inventory).
Adding debt only works if you can earn more than the interest rate on that debt.

19
Conversely, if Co. B had earned less than the borrowing costs, the shareholders would be worse off from the borrowing
because they still have to pay the interest and the difference comes out of the shareholders’ pockets. In practice, it is a little
more complicated than that, but that is the basic idea and the details will be covered in your finance classes.
72
 CHAPTER 6: PRO FORMA ANALYSIS

For many purposes (e.g., valuation, budgeting, mergers, strategic planning, credit analysis, business
plans, etc.), you will need to prepare pro forma financials. Much of the reason we spend so much time
early in the class on preparing Balance Sheets, Income Statement and Statements of Cash Flows is
because, even if you are not an accountant, you will often need to be able to create forecasted financial
statements.

Given the development to this point, we have relatively little new to say about pro formas. Further,
while pro formas are important in practice, most of the difficult work is in coming up with reasonable
assumptions, which is beyond the scope of this class (it requires you to factor in marketing, operations,
microeconomics, strategy and all the other topics that affect the future prospects of the firm). Therefore,
our goal is simply to help you understand the machinery that underpins forecasting financial statements
and a little about the developing underlying assumptions.

The steps to preparing pro formas are the following: start with a forecasted Income Statement, next
forecast the Balance Sheet and then back into an implied Statement of Cash Flows. This is called a
“three statement model” which is common in a variety of settings (Google it if you are curious). 20 The
goal is to come up with financial statements that reflect realistic assumptions and are internally
consistent (i.e., the Statement of Cash Flows follows from the Balance Sheet and Income Statement).

Pro Forma Income Statement

Sales
We always start our pro forma with a sales forecast. In practice, it is worth spending time on this step
because everything else follows from the sales forecast. Analysts, for example, spend a great deal of
time coming up with good sales forecasts based on, for example, likely trends by country, product line,
demographic group, etc. For a company like Coke, we start with past experience in term sales growth
rates and then layer on factors that may make the past growth unrepresentative of the future (e.g.,
regulation, changes in consumer preferences, economic downturns, etc.). For a start-up, of course, this
is much more challenging and is based on factors such as industry knowledge, expected market share,
etc. But, even if it is difficult, it is crucial to do the best you can with the information available.

Cost of Goods Sold

Once you have forecasted sales, the rest follows logically. Moving down the Income Statement, Cost of
Goods Sold is typically forecasted based on the past percentage of Sales. Assuming the cost of
inventory is relatively stable, we can use the past gross margin percentage to forecast future Cost of
Goods Sold. Of course in practice we would want to tweak it for factors such as expected changes in
commodity prices, product mix, efficiencies, etc. For a company like Coke, Cost of Goods Sold is a
fairly constant percentage of Sales.

20
When I Google it, the first hit is: http://www.streetofwalls.com/finance-training-courses/investment-banking-technical-
training/three-statement-financial-modeling/ with the quote: “Investment banking analysts and associates are expected to be
able to build three-statement operating models as part of their day-to-day responsibilities. In fact, in most cases, analysts and
associates will spend as much time performing this task as any other. Therefore, it is extremely important that any investment
banking professional or candidate be well versed in how to build a three-statement operating model to completion.”

73
Selling, General and Administrative Expense
Again, we would typically start with a percentage of Sales based on past experience. While there are
fixed costs here, SG&A typically varies fairly closely with sales. Again, we would tweak it for factors
such as large advertising campaigns (e.g., the Olympics), expected restructurings, etc.

Other Operating Items

Often these are one-time items based on, for example, asset impairments. Again, it is useful to look at
past history to see whether they happen predictably. If they are infrequent and nonrecurring, it may be
safe to assume they will be zero going forward. If they reflect ongoing activities (e.g., Coke’s bottling
investments), it may require additional analysis into their source.

Interest Expense
This ties back to the amount of debt assumed on the Balance Sheet and expected interest rates. We will
come back to this when we discuss the Balance Sheet.

Income Tax Expense

Based on the preceding, we know pretax income. We need a tax rate to compute income tax expense.
Typically, we can compute an “effective tax rate” based on past income tax expense as a percentage of
pretax income and use that as a basis going forward. Again, we would adjust the rate for expected
future changes in terms of expected legislative action, geographic income mix, etc. Subtracting off
income tax expense gives us forecasted net income.

Pro Forma Balance Sheet

Cash
Normally cash balances grow with the growth of sales (more cash is needed as the business grows).

Operating Assets and Liabilities

Items such as accounts receivable, inventories, prepaids, accounts payable, accrued expenses, etc., likely
grow with the growth rate of sales. Again, tweaks may be necessary based on expectations. For
example, accounts receivable tie to credit sales, inventories and accounts payable tie to cost of goods
sold and accrued salaries tie to selling, general and administrative expense.

Property, Plant and Equipment

PP&E likely needs to grow as the company grows. There are two pieces to be forecast here. First,
depreciation is typically a percentage of the overall balance in gross PP&E and reduces net PP&E as it
accumulates. As a result, capital expenditures need to be sufficient to sustain the necessary growth in
net PP&E. Note also that depreciation expense needs to be consistent with the assumption on the
Income Statement.

Retained Earnings
The change in Retained Earnings is Net Income minus Dividends. Most companies have target dividend
payout ratios as a percentage of Net Income, and Retained Earnings increases by Net Income minus
Dividends.

Financing Liabilities and Equity

This is typically the last step. Note that, for the Balance Sheet to balance, something has to be a plug
(i.e., if you measured each line independently, there would be nothing to constrain the Balance Sheet to

74
balance). The plug here is the answer to the question, “What does the company do when it has too much
cash or needs additional cash?” The answer is that it typically either increases (if it needs cash) or
decreases (if it has too much cash) Long Term Debt or Contributed Capital. Coke, for example, uses
excess cash to buy back shares (reduce Contributed Capital). Other companies might use excess cash to
pay down debt. Similarly, companies which are short of cash might issue new shares (Contributed
Capital) or borrow more (Long Term Debt). For Coke, we will assume they keep Long Term Debt
constant and use excess cash to repurchase shares. As a result, we will forecast every line other than
Contributed Capital and will plug Contributed Capital to make the Balance Sheet balance.

Statement of Cash Flows

As we’ve seen, it is relatively straightforward to prepare a Statement of Cash Flows from two Balance
Sheets and an Income Statement, and there is nothing new here. One thing to note is that the change in
Contributed Capital or Long Term Debt is essentially telling you where the excess cash came from or
went to based on the plug to the Balance Sheet discussed above. Another way you could think about it
(which is more of the way the firm thinks about it and gives the same answer) is that, rather than the
plug being to the Balance Sheet, the plug is to the Statement of Cash Flows. In other words, the firm has
a target level of cash they want to keep on hand for operating purposes. In addition, the firm adds assets
and liabilities during the period for investing and operating purposes, which implies a change in cash
absent financing. If the cash generation of the firm does not imply the desired change in cash during the
period (and it generally wouldn’t), the firm uses financing to make up the difference. If the firm has too
little cash, it issues stock or issues debt. If the firm has too much cash, it repurchases shares or pays off
debt. In Coke’s case, excess cash is used to repurchase shares.

75
 CHAPTER 7: VALUATION AND EVALUATION

7.1 VALUATION

Our goal in this section is to understand how accounting information finds its way into equity valuation.
There are a variety of approaches, but we will consider three of the most common: the Dividend
Discount, Discounted Cash Flow and Balance Sheet approaches. Choice of a method is a function of
what attribute (dividends, free cash flows, or fair values) is easiest to estimate. Multiple methods are
often used together.

7.1.1 Valuation using Discounted Dividends

The first approach, which underpins all other methods, is the Dividend Discount approach. This is the
most fundamental approach because, at the end of the day, financial assets only have value if they are
expected to generate cash flows to the holders. The Dividend Discount approach looks directly to the
expected payouts to shareholders in valuing the stock. There are a few different variants, but we will be
focusing on one that defines “Dividends” as dividends plus share repurchases and values the total equity
of the firm, after which we divide by shares outstanding to get implied share price.

The principle here is simple. Think about the firm as a black box that provides cash flows to
shareholders. Those cash flows take one of two forms: dividends and share repurchases.21 If we take
expected dividends and share repurchases and discount those back, that is the value of the equity. It is
analogous to how we would value a debt instrument with the dividends being analogous to the interest
payments and the repurchases being analogous to the principal repayment. The valuation formula is:

Equity Valuet = E(Divt+1)/(1+r) + E(Divt+2)/(1+r)2 + …

where Div is dividends (including share repurchases) and r is cost of capital.

Advantages: Focuses on what ultimately determines value (cash flows to equity holders).
Disadvant.: Dividends are generally discretionary and hard to predict.
For low dividend firms, much of value is imbedded in the distant future.

Going forward, we will treat dividends and repurchases as economically identical, which is accurate
ignoring taxes and transactions costs. To see why this is the case, consider the following example. The
point of the example is to show that, from the company’s perspective, a repurchase is no different from a
dividend. Similarly, the two are equivalent from the shareholder’s perspective in the sense that, given
one, the shareholder can create the other. It is not important that you be able to work through the
example since it is a finance concept, but many students have a hard time accepting the equivalence. If
you are willing to accept the equivalence on faith, you can skip the example.

21
Technically any additional contributed capital should be netted out, but we will generally assume there will be no
additional capital contributions for an established company.
76
Example of Dividend/Repurchase Equivalence
In this example, the company has 100K shares outstanding at $10/share and you own 100 of those shares
or 0.1% of the company.

Company: 100K shares outstanding x $10/sh. = $1,000K market capitalization

You: 100 shares x $10/sh. = $1,000 worth, or 0.1% of the company

What if the company pays a dividend of $200K in total ($2/share)?

Case 1: Now the company has $200K less of assets (and therefore $200K less of equity and market
capitalization). You receive $200 of cash and still own 0.1% of the company, but your share is now
worth $800 so you still have total assets of $1,000 (you are no better or worse off):

Company: 100K shares outstanding x $8/sh. = $800K market capitalization

You own: 100 shares x $8/sh. = $800 worth of stock (0.1% of company) + $200 cash = $1K

Case 2: You don’t like the fact that they paid you a dividend, so you buy shares on the market with your
$200 = 25 shares x $8/sh. You are back to having $1,000 invested in the company (the company is
unaffected by your action), but you now own 125/1,000 shares = 1.25% of a $800K company.

Company: 100K shares outstanding x $8/sh. = $800K market capitalization

You own: 125 shares x $8/sh. = $1,000, (125/100K = 0.125% of company)

What if, instead, the company repurchases 20K shares for $10/share, spending $200K in total?

Case 3: If you do nothing, you still have your 100 shares worth $10/share, but you now own 1.25% of
the company. The company has 80K shares outstanding and a market cap of $800K:

Company 80K shares outstanding x $10/sh. = $800K market capitalization

You: 100 shares x $10/sh. = $1,000 worth or 100/80K = 0.125% of the company

This is economically identical to Case 2 in which the firm paid the dividend and you reinvested in that
you have $1,000 invested and own 0.125% of a company with a market value of $800K.22

Case 4: You wish you had gotten a dividend (e.g., you need cash), and decide to sell 20 shares. You
now have 80 shares at $10/share = $800 plus $200 in cash and own 0.1% of the company

Company 80K shares outstanding x $10/sh. = $800K market capitalization

You: 80 shares x $10/sh. = $800 or 80/80K = 0.1% of the company + $200 cash
This is economically identical to Case 1 with the dividend. You have $800 in shares, $200 in cash and
own 0.1% of a company worth $800K.
Across all the cases the firm is indifferent between paying a dividend and repurchasing shares. The
investor is also indifferent (ignoring taxes and transactions costs) because they can convert a dividend
into a repurchase and vice versa.
22
It isn’t really identical in the sense that you now have 125 shares worth $8 each = $1K and own 0.125% of the company. In
Case 2, you had 100 shares worth $10 each = $1K and own 0.125% of the company. If you value money or percentage share
ownership you are equally well off. If you are fixated on the number of pieces of paper you own, you might prefer Case 2.
77
7.1.2 Valuation using Discounted Free Cash Flows

The Dividend Discount approach is conceptually straightforward. However, it is often difficult to apply
in practice. A second approach which is more common is to value shares based on the expected cash
flows into the firm. This approach is valid because it is ultimately the cash flows into the firm that
create the ability to pay dividends and repurchase shares. (I will spare you the algebraic proof.)

As we will apply it, the valuation model is:

Equity Valuet = Enterprise Valuet – Existing Interest-Bearing Debtt (net of excess cash)
= (E(AFCFt+1)/(1+r) + E(AFCFt+2)/(1+r)2 + …) – Existing Interest-Bearing Debtt (net of excess cash)

where:
Enterprise Value = E(AFCFt+1)/(1+r) + E(AFCFt+2)/(1+r)2 + …
AFCF = (Cash from Operations + Cash from Investing) + (Interest Expense x (1 – Tax Rate))

Advantages: Focuses on cash inflows, which are usually easier to predict than dividends.
Disadvantages: Generally have to forecast earnings and the balance sheet to infer free cash flows.
Cash flows are generally more volatile than earnings.

The basic idea behind this approach relates back to the intuition underlying the Statement of Cash Flows
and Return on Assets (ROA). The goal is to first compute “Enterprise Value” based on the expected
cash flows to the assets (from operations and investing, before interest). As the name implies,
Enterprise Value is the value of the entire firm, before the effects of financing. It is a concept you will
also hear about in finance class. The interest add-back is similar to the add-back for interest in coming
up with ROA and the intuition is the same (to calculate the cash flows before the effect of financing).
As with ROA, we add back after-tax interest (i.e., (Interest Expense x (1 – Tax Rate))).

Once we know the value of the entire enterprise, we need to recognize that there are debt financing
claims in addition to equity. As a result, we subtract off the financing claims against those assets
(existing interest-bearing debt) to arrive at the value of the equity. More specifics will be covered in
finance class but that is the basic idea. For our purposes, it is sufficient that you take as given the Equity
Value equation above. A few more details follow for those who are curious.

A trick we will use is to assume that financing (i.e., interest-bearing) debt remains constant going
forward. As a result, we subtract existing interest-bearing debt and add back a constant amount of after-
tax interest expense going forward. The reason we are able to ignore future debt is that the amount
received if a firm issues new debt is equal to the present value of future interest and principal
repayments (i.e., new debt is a zero net present value project), so ignoring it doesn’t change the answer.

We cannot ignore existing debt because there is no future cash inflow (only outflows), so the net present
value is negative. However, the trick we apply here is that the book value of existing debt is equal to the
present value of remaining future cash outflows as discussed in the earlier section on liabilities. One
twist which has emerged in recent years is what to do about “excess cash.” Traditionally, it was OK to
assume that all cash was “operating” because firms did not hold more cash than they needed for
operations. However, recently it has become unrealistic to assume all cash is needed for operations
because low interest rates, US tax policy and risk aversion have caused firms to hold excess cash. As a

78
result, we will effectively assume that firms use “excess” cash to pay off some debt. We will discuss
more in class about how we define “interest-bearing debt” and “excess cash.”

Here is the bottom line, we value the assets (enterprise) first, based on the present value of operating and
investing cash before the effects of financing. Then we subtract off the piece that belongs to the debt
holders (existing interest-bearing debt, net of excess cash) to get us to the piece remaining that belongs
to the equity holders.

7.1.3 Balance Sheet Valuation

The final approach recognizes that, if the Balance Sheet reflected economic reality well, we could
simply use the book value of equity to value the shares of the firm. However, we know that the Balance
Sheet misvalues some assets and liabilities, and leaves other assets and liabilities off the books entirely.
In terms of fair values,

FV(Equityt) = Fair Value (Assetst) – Fair Value (Liabt)

FV(Assetst) = Book Value (Assets) + Missing Assets + (FV – BV) of Misvalued Assets
FV(Liabt) = Book Value (Liab) + Missing Liab + ((FV – BV) of Misvalued Liab), or,

FV(Equity) = BV(Equity) + Missing Assets + ((FV – BV) of Misvalued Assets) – Missing Liab – ((FV
– BV) of Misvalued Liab)

where fair values of assets and liabilities start with the Balance Sheet and are adjusted by revaluing
assets and liabilities and adding new assets and liabilities as appropriate. FV and BV refer to fair value
and book value.

Advantages: Uses someone else’s effort (e.g., investors in a market) in assessing value.
Disadvant.: Most assets don’t have readily available market prices (e.g., PP&E and intangibles)
Firm’s cash flows from an asset may differ from someone else’s (e.g., custom PP&E)

Here the trick is to start with the book value of assets and liabilities (and, therefore, equity) and make
adjustments. The concept is simple. If accounting was accurate, it would reflect the true values of
assets, liabilities and, therefore, equity, so that is our starting point. Then, we recognize that some assets
are left off the Balance Sheet (e.g., internally-developed intangibles) so we add them in. In addition,
some assets are misvalued on the Balance Sheet (e.g., land purchased years ago), so we adjust them to
fair value by adding the difference between fair value and book value.

We do the same with liabilities. Some liabilities are left off the Balance Sheet (e.g., lawsuits and other
contingencies) and other liabilities are potentially misvalued (e.g., polluted land may be expected to cost
more to remediate than the associated reserve liability set up by the firm).

One way to view this approach is as valuing the company as if we were planning to break it up, sell off
the pieces and pay off the debt. As a result, it is likely to undervalue a company like Coke with
significant synergies among the asset components that make it worth more as a whole than in pieces.

79
80
 CHAPTER 8: ACCOUNTS RECEIVABLE

Recall that we said that you shouldn’t carry an asset on the books for more than it is worth. Think about
credit sales totaling $1,480K (numbers are from problem 7.1 below). Assume the Cost of Goods Sold is
zero just for convenience (e.g., you are running a services firm). At the time of sale, you would record:

Account Receivable 1,480.0

Sales Revenue 1,480.0

Your Balance Sheet would show a receivable of $1,480 and your Income Statement would show $1,480
of profits (assuming no expenses). But, how would you deal with bad debts? There are two methods
(really only one in practice for financial reporting purposes, but the other for illustrative purposes): the
Direct Write-off Method (required for tax, but not permitted for financial reporting) and the Allowance
Method (required for financial reporting).

Direct Write-off Method

One conceptual possibility is to wait until something actually goes bad and then write it off. This is
called the Direct Write-Off Method. This method is required for tax purposes, but not allowed for
financial reporting purposes.

Under the Direct Write-Off Method, you would record nothing for bad debts at the time of sale.
Suppose that, during the next period, $12 went bad (e.g., a customer went bankrupt and you expect to
collect nothing). You would record the following:

Bad Debt Expense 12

Accounts Receivable 12

What if you later realized that it was still alive (e.g., someone bought them out of bankruptcy)? You
would reverse out the previous entry (essentially it was in error):

Accounts Receivable 12
Bad Debt Expense 12

and, when you later collected, you would record:

Cash 12
Accounts Receivable 12

So, why is the Direct Write-off Method not allowed for financial reporting purposes? Note that, in the
period of the sale, you would be carrying the receivables at $1,480, but you don’t expect to receive
$1,480 because best case you get $1,480, but there is some probability you will receive less than the full
amount because some receivables may go bad. In other words, you are carrying the asset on the books
for more than you think it is worth. Therefore, your Balance Sheet and Income Statement are overstated
in the period of the sale. Also, bad debts hit in the “wrong” period in the sense that the bad debt was
caused by selling to the “wrong” people, but the expense hits in a later period.

81
Allowance Method

This method is required for financial reporting purposes and reduces the asset and profitability in the
period of the sale based on an estimate. Suppose you have a long history, things are stable and you
expect that 4% ($1,480 x .04 = $59.2) will ultimately go bad. The sale journal entry is the same as
above. However, in addition you also record, in the period of the sale:

Bad Debt Expense (Income Statement) 59.2

Allowance for Doubtful Accounts (Contra Asset) 59.2

Assuming nothing else happened, in the period of the sale you would have a Balance Sheet that showed
the amount you expect to collect ($1,420.8 is 96% of $1480.0):

Accounts Receivable $1,480.0

Less: Allowance for Doubtful Accounts - 59,2
Accounts Receivable, Net $1,420.8

and the Income Statement would incorporate the portion you expect to go bad:

Sales Revenue $1,480.0

- Bad Debt Expense -59.2
Net Income $1,420.8

Then, when something goes bad (e.g., a customer bankruptcy) for $12.0 during the next period, you
would simply take it out of the allowance account:

Allowance for Doubtful Accounts (Contra Asset) 12.0

Accounts Receivable 12.0

Your t-accounts would be (if nothing else happened):

Accts. Rec. (Gross) Allow. for Doubtful Accts. Accts. Rec. (Net)
BB = 1,480.0 BB = 59.2 BB= 1,420.8
12 Write-off 12 Write-off

EB = 1,468.0 EB = 47.2 EB= 1,420.8

Note that the effect of the write-off on the Income Statement and on Accounts Receivable (Net) on the
Balance Sheet is zero. That is because you already knew something like this was going to happen so you
reduced Net Accounts Receivable and Net Income (based on an estimate) in anticipation of it. If you
recorded another reduction to the Balance Sheet and Income Statement when the receivable actually
went bad, you would be double counting.

Now, let’s assume that the account you wrote off is later discovered to still be alive. You would reverse
out the write-off (it was a mistake):

82
Accounts Receivable 12.0
Allowance for Doubtful Accounts (Contra Asset) 12.0

and, when you collect, you would record:

Cash 12.0
Accounts Receivable 12.0

Note that, as with the write-off, there is no direct effect on the Income Statement of the recovery (the
journal entries take you right back to where you were before the write-off). You are essentially just
correcting an error. Note also that we run the amounts back through Accounts Receivable even if we
collect the cash immediately because we want the Accounts Receivable account to contain a record that
the account was initially written off but later recovered. Conceptually, each customer has their own
accounts receivable t-account and we want to keep track of the history so we can decide whether to sell
to them on credit in the future.

Could there be indirect effects of write-offs and recoveries? Yes, if the write-offs or recoveries are
higher than expected and throw off the balance in the allowance account. So, for example, if we go back
to the write-off of $12 above (assuming there was no recovery), if the effect was to reduce the remaining
allowance below what was appropriate given the accounts still in Accounts Receivable we would need
to make a further adjustment. For example, if the auditor decided that the ending balance in the
allowance account should be $57.2 (it is now $47.2), you would need to record:

Bad Debt Expense (Income Statement) 10.0

Allowance for Doubtful Accounts (Contra Asset) 10.0

Accts. Rec. (Gross) Allow. for Doubtful Accts. Accts. Rec. (Net)
BB = 1,480.0 BB = 59.2 BB= 1,420.8

10 added 10 added to
12 Write-off 12 Write-off to ADA ADA

EB = 1,468.0 EB = 47.2 EB= 1,410.8

Note that that entry does affect the Income Statement and Net Accounts Receivable on the Balance
Sheet. That is essentially what happened in the financial crisis. Banks had recorded small allowances
against mortgages during a period in which default rates had historically been, and were expected to
remain, low. Once the economy began to deteriorate, they realized that the allowances were inadequate
and had to record huge losses to bring allowance accounts up to appropriate balances.

Note also that, if the allowance became too large by $10 (i.e., things turned out better than expected), we
would reduce the allowance account and bad debt expense, which would increase profitability:

Allowance for Doubtful Accounts (Contra Asset) 10.0

Bad Debt Expense (Income Statement) 10.0

This is what happened in the aftermath of the financial crisis. Allowances for the banks were too large
so they reversed a portion of them out, leading to record profits.
83
Problem 8.1 Journal entries for the allowance method

Step Green Technologies, a clean tech company from Connecticut, has the following sales and write-off
data:

Accounts Written Off as Uncollectible in Year

Year Sales on Acct. Year 1 Year 2 Year 3 Year 4 Year 5
Year 1 $ 1,480 $ 12.0 $ 18.3 $ 25.6 - -
Year 2 $ 1,080 - $ 17.3 $ 16.3 $ 18.0 -
Year 3 $ 950 - - $ 17.4 $ 10.4 $ 11.2
Total $ 3,510 $ 12.0 $ 35.6 $ 59.3 $ 28.4 $ 11.2

Assume that uncollectible accounts occur within three years of the year of sale. Step Green
Technologies estimates that 4% of sales on account will ultimately become uncollectible.
Prepare journal entries to recognize bad debt expense and to write off uncollectible accounts for Years 1,
2 and 3 using the allowance method.

84
 CHAPTER 9: MANUFACTURING AND ABSORBTION COSTING

When Walmart buys a toaster oven, it records the inventory at the all-in cost of acquiring the inventory.
That includes, for example, taxes and shipping, but we don’t normally think much about those pieces
because they tend to be minor. What if GM builds a car? The same principle applies, but it costs far
more to build a car than just the cost of the parts.

In general, we will conceptualize manufacturing costs as falling into three buckets: Direct Materials,
Direct Labor and Overhead. Direct Materials are materials that are directly tracked to units being
produced. In the case of GM, those would be tires, engine, etc. (although they manufacturer some of the
components, let’s assume they buy them). Direct Labor is the labor that can be tied to specific batches
(e.g., workers on the assembly line). Overhead includes all of the other costs associated with production
(e.g., utilities for the plant, depreciation on the plant, indirect labor (e.g., supervisory and janitorial
labor) and indirect materials (e.g., rags, grease, screws, etc.)). The distinctions between “direct” and
“indirect” labor and materials have more to do with how you keep track of costs internally than being
conceptually different. Direct Material and Direct Labor are “direct” because they are tracked to
specific units of product, while Overhead is allocated to units of inventory based on “drivers” such as
Direct Labor (e.g., compute total Overhead for the period and allocate it to inventory based on the
proportion of Direct Labor expended in producing that batch of inventory). How to keep track of all of
the pieces is not our problem—it will be covered in Managerial Accounting. For our purposes, assume
we are given the amounts of Direct Material, Direct Labor and Overhead that belong to a specific batch
of inventory.

The only other new piece is that we now split inventory into three pieces (analysts said they want to
know the pieces)—Raw Materials, Work-in-Process (WIP) and Finished Goods. Conceptually the
accounting is easy because it follows the physical flow. When you buy raw materials, they go into the
Raw Materials Inventory account. Assuming that you buy them on credit, the entry is:

Raw Materials Inventory 100

Accounts Payable 100

When you move the raw materials onto the plant floor, the associated costs get moved from Raw
Materials to Work-In-Process Inventory.

Work-in-Process Inventory 100

Raw Materials Inventory 100

When you add labor and overhead on the plant floor, the costs get added to Work-In-Process.23 For
example, when production line employees work on the batch, assuming they are paid in cash, you
record:24

Work-in-Process Inventory 50
Cash 50

23
Technically, labor and overhead could come in the raw materials and finished goods warehouses, but we will assume they
all come in on the plant floor.
24
This often strikes students as odd because labor is becoming part of an asset, but it makes sense because the goal is to
compute the total cost of manufacturing the inventory.
85
Overhead is allocated to the batch. Let’s assume it is depreciation on the machinery because that is the
weirdest one. Part of the cost of doing business is using up a piece of machinery. You want to reflect
that cost in the overall inventory cost while reflecting the reduced value of the plant on your books
through Accumulated Depreciation. Therefore, you record:

Work-in-Process Inventory 75
Accumulated Depreciation 75

When you complete the production (let’s assume no other costs), you record (for this batch):

Finished Goods ($100+$50+$75) $225

Work-in-Process Inventory $225

The $225 becomes Cost of Goods Sold when you sell the inventory. Ignoring the sales revenue entry:

Cost of Goods $225

Finished Goods Inventory $225

Below are the three inventory t-accounts within the overall inventory account. The numbers are from
the above. Note that this example follows a given set of costs through the process.25

Raw Materials Work in Process Finished Goods

Beg. Bal. Beg. Bal. Beg. Bal.

Purchases Transfers Transfers Transfers Transfers To Cost of

100 to WIP from RM to FG from WIP Goods Sold
100 100 225 225 225
Labor
50
Overhead
75

End. Bal. End. Bal. End. Bal.

Here is an example of an inventory disclosure for Callaway Golf in 2013.

We will work through a complete manufacturing problem in class.

25
In practice, the amount coming into a given t-account during a period will generally not be equal to the amount going out
in the same period (e.g., some existing inventory will be used up and some new inventory will be added).
86
Problem 9.1: Preparation of journal entries and Income Statement for a manufacturing firm.

Newton Beverages, an apple juice manufacturer, listed the following amounts in its inventory accounts
on January 1 (all numbers in $ thousands):

Raw Materials Inventory $ 419

Work-in-Process Inventory $ 101
Finished Goods Inventory $ 401
Total Inventory $ 921

The following occurred during the year:

(1) Newton acquired raw materials (apples, sugar, etc.) totaling $734, all on account.

(2) Newton transferred $758 of raw materials to the production floor.

(3) Newton paid salaries and wages totaling $601 to employees for work done during the year. Of the
total, $476 was for factory workers, $100 for sales personnel and $25 for administrative workers in
the headquarters.

(4) Newton recorded depreciation on buildings and equipment totaling $310. Of the total, $201 related
to manufacturing facilities, $96 to salesrooms and $13 to the administrative facilities.

(5) Newton paid utilities and other operating costs incurred during the year totaling $339. Of the total,
$240 related to manufacturing, $61 to sales and $38 to administration.

(6) The cost of goods manufactured and moved to the finished goods storage area totaled $1,721.

(7) Sales on account during the year totaled $2,640.

(8) A physical inventory taken at year-end revealed an ending finished goods inventory of $232. (Note:
you have to compute cost of goods sold based on the transfers from WIP and ending balance.)

87
 a) Record journal entries for the transactions and events that occurred during the year.

b) Prepare an Income Statement for Newton Beverages. Ignore income taxes.

Selected t-accounts

Raw Materials Inv. Work-in-Process Inv. Finished Goods Inv

Sales Revenue Costs of Goods Sold Selling & Administrative Exp.

Income Statement

Sales Revenue
- Cost of Goods Sold
- Selling & Administrative Expense
Net Income

88
CHAPTER 10: INTERCOMPANY INVESTMENTS

Generally Accepted Accounting Principles highlight three types of intercompany investments based on
level of ownership. The cutoffs are not intended as bright lines but are often treated as such in practice.
Each of the three has a different accounting treatment.

1. Marketable securities with less than 20% ownership of the company. These are generally
assumed to be passive and nonstrategic.
2. Equity method investments with 20-50% ownership. These are generally assumed to be strategic
with some influence, but less than complete control.
3. Consolidated entities with greater than 50% ownership. These are assumed to represent
complete control.

Marketable Securities

We don’t carry most assets at fair value on the Balance Sheet because they are difficult to value for at
least two reasons. First, there are not ready markets for many assets (e.g., a Coca Cola concentrate plant
in Singapore). Second, and more importantly, “value in use” is generally different from “value in sale.”
For example, the Coke concentrate plant is Singapore is probably worth much more to Coke than it
would be to another owner (and Coke doesn’t plan to sell it). As a result, it is not clear that a
hypothetical selling price would be relevant to investors even if one could be obtained. However, some
classes of assets (e.g., passively-owned stocks and bonds that are publicly traded) are relatively easy to
value and have the same value to anyone who owns them. Therefore, it is difficult to argue that they
should be carried at historical cost given that objective market values are readily available.

While in theory it might seem reasonable to carry financial instruments that are relatively easy to value
at fair value, the issue has been very controversial, in part because, to keep the Balance Sheet in balance,
a natural implication is that “paper” gains and losses would flow through the Income Statement.
Ultimately a compromise was reached in which there are three categories of marketable securities based
on your intent for holding them, each with a different accounting treatment. The same bond could have
any of the three treatments based on intent. The three categories are Debt Held to Maturity, Trading
Securities and Securities Available for Sale. As of a recent accounting change, equity marketable
securities can only be carried as Trading Securities.

Let’s assume that you acquire stocks or bonds on June 30, Year 1, for $17.5. Irrespective of the category
of marketable securities, when you buy the security, you would record:

Marketable Securities (B/S-A) 17.5

Cash 17.5

When the securities pay dividends or interest you would record:

Cash 1.0
Dividend or Interest Revenue (Income Statement) 1.0

89
The difference between the three categories relates to whether you revalue the securities subsequent to
acquisition. That depends on what category they belong in which, in turn, depends on your intent in
purchasing them. The same debt security could potentially fall into any of the three categories based on
intent.26

Trading Security

Trading Securities are conceptually at one extreme for accounting purposes. Equity securities (along
with many other financial instruments such as derivative) are accounted for as trading securities. In
addition, debt securities are treated as Trading Securities if they are held for speculative purposes (e.g.,
on the trading desk at a bank). We record the purchase and interest/dividend as above. However, we
revalue the asset every period and run the revaluation through the Income Statement. This is referred to
as “marked to market through the Income Statement.” The “mark to market” indicates that we carry the
asset on the books at market value and the “through the Income Statement” refers to the fact that
changes in asset values are reflected on the Income Statement.

In terms of journal entries, recall that we purchased the security for $17.5 and recorded the purchase as
above (the asset is initially on the books at $17.5). Assume that the value of the security increases to
$18.0 at the end of Year 1, increases again to $19.9 at the end of Year 2, and is sold for $19.1 in Year 3.

6/30/Yr 1 12/31/Yr 1 12/31/Yr 2 6/30/Yr 3

Asset Value: $17.5 $18.0 $19.9 $19.1

Therefore, at the end of Year 1, we would mark the asset up to market by $0.5:

Marketable Security (Trading Security) 0.5

Unrealized Gain (I/S-Gain) 0.5

At the end of Year 2, we would mark the asset up by another $1.9:

Marketable Security (TS) 1.9

Unrealized Gain (I/S-Gain) 1.9

At the end of Year 2, the Trading Security would be on our books for $19.9 (the market value). Note
that the Unrealized Gain account has no balance because it (like every Income Statement account) is
cleaned out each period by the closing entry (noted CE).

Mktable Sec. (Trading) Unreal. Gain (I/S)

BB: 17.5 BB: 0.0
0.5 CE 0.5 0.5
1.9 CE 1.9 1.9
EB: 19.9 EB: 0.0

If, on June 30, Year 3, we sell the security when the price is $19.1 (i.e., the price has dropped by $0.8
from the last revaluation), we would record:

26
If you find it troubling that we would account for securities differently based on intent, you probably should (at least the
FASB does). The banks would argue that it is not as arbitrary as it sounds and that they have designated desks that deal with
Held-to-Maturity, Trading and Available-for-Sale securities given the differences in intent.
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Cash 19.1
Realized Loss (I/S-Loss) 0.8
Marketable Security 19.9

Note that the gains or losses hit the Income Statement irrespective of whether you sell the securities or
not. Focusing on the Income Statement and Balance Sheet, the pattern over the life of the Trading
Security is as follows. Note that the Balance Sheet records the asset at fair value each period.

Income Statement 12/31/Yr 1 12/31/Yr 2 12/31/Yr 3 Total

Gain (Loss) on Trading Securities + $0.5 + $1.9 - $0.8 + $1.6

Balance Sheet

Marketable Security (Trading) $18.0 $19.9 $0.0

The FASB would argue that this treatment reflects economic reality. The asset is carried at what it is
actually worth and the Income Statement reflects gains and losses each period as the price changes.
Over the life of the asset the total gain ($1.6) represents the difference between the purchase price
($17.5) and selling price ($19.1) but the Income Statement effect is spread over the years based on price
changes.

The other two accounting treatments are only permitted for debt securities.

Debt Held to Maturity

Here the firm plans and commits not to sell the bond before maturity.27 Let’s assume a bond with no
default risk (i.e., ignoring impairments). Accounting for Debt Held to Maturity is straightforward
because we simply apply historical cost accounting. We record the purchase and interest revenue
journal entries above. If the bond later changes value due to interest rate movements, we generally do
not adjust the value on the books. When the bond pays back the principal amount, we record,

Cash 17.5
Marketable Security (Held-to-Maturity) 17.5

Securities Available for Sale

This category includes all marketable securities that don’t fit into one of the other two buckets (they are
not held for speculation (Trading) or Debt Held to Maturity). They are revalued to market every period,
but not through the Income Statement (through Accumulated Other Comprehensive Income in
Shareholders’ Equity). We record the purchase and interest/dividend as above. However, when the
security increases in value to $18.0 at the end of Year 1, we record:

Marketable Security 0.5

Unrealized Gain (B/S-SHE-AOCI) 0.5

27
Equity securities (e.g., stocks) cannot be Held-to-Maturity because they have no maturity date.
91
Note that the preceding journal entry looks almost identical to the journal entry for Trading Securities.
The important distinction is that the Unrealized Gain does not run through the Income Statement (it is in
“special” Shareholders Equity on the Balance Sheet as part of an account called Accumulated Other
Comprehensive Income, which is neither Contributed Capital nor Retained Earnings).28

If the value of the security increased again to $18.9 at the end of Year 2, we would record:

Marketable Security 1.9

Unrealized Gain (B/S-SHE-AOCI) 1.9

Now it is on our books for $19.9, just as though it had been a Trading Security (both are marked to
market). However, the important point is that the Unrealized Gains are not cleaned off in the closing
entry because they are not on the Income Statement. As a result, when we go to sell the security, we
have to remove both the asset as well as the AOCI piece manually because it didn’t get cleared off
automatically as part of the closing entry. Before the sale, our balance sheet accounts are as follows:

Marketable Security Unreal. Gain (AOCI)

17.5
0.5 0.5
1.9 1.9
19.9 2.4

As before, suppose we sell the security during Year 3 for $19.1. We would record:

Cash 19.1
Unrealized Gain (Balance Sheet: SH Equity-AOCI) 2.4
Marketable Security 19.9
Realized Gain (Income Statement: Gain) 1.6

Note that two lines in the preceding entry are basically the same as for a Trading Security. First,
unsurprisingly, the Cash received is $19.1. Second, the Marketable Security, which was on the books
based on the Year 2 revaluation, is taken off at $19.9.

Two things are new here. First, we have to manually clean out the Unrealized Gain account because it
wasn’t cleaned out in the closing entry (it didn’t hit the Income Statement) and we don’t want the
Unrealized Gain left on the Balance Sheet once the security has been sold. That explains the debit to the
Unrealized Gain account. Second, we recognize the entire gain on the security at the point of sale. The
Realized Gain is the difference between the selling price ($19.1) and the purchase price ($17.5).

On the Balance Sheet the carrying value of the security is the same as it was with Trading Securities:

Balance Sheet

Marketable Security (Trading) $18.0 $19.9 $0.0

Marketable Security (Avail. for Sale) $18.0 $19.9 $0.0

28
Accumulated Other Comprehensive Income also includes items such as foreign currency translations which the FASB has
decided belong in Shareholders’ Equity but not on the Income Statement.
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On the Income Statement, the gain is spread over time for the Trading Security, but all recognized at the
end for Available for Sale.

Income Statement 12/31/Yr 1 12/31/Yr 2 6/30/Yr 3 Total

Gain (Loss) on Trading Securities + $0.5 + $1.9 - $0.8 +$1.6

Gain (Loss) on Avail. for Sale $0.0 $0.0 +$1.6 +$1.6

While banks generally do not like the Balance Sheet volatility induced by Available for Sale securities,
they prefer that treatment to Trading Securities because it permits them to keep volatility off the Income
Statement. Further, banks can “cherry pick” gains and losses on Available for Sale securities, so they
are recorded in preferred periods by choosing when to sell the securities.

Equity Method Investments

Once you move above 20%, the presumption is that the holding is strategic and, therefore, it is worth a
different amount to the holder than it would be worth to someone else (e.g., Coke’s holding of bottlers is
worth a different amount to Coke than it would be to Walmart). Therefore, you don’t mark to market
because the value to the firm is so uncertain.

When you buy it, you record it at what you paid:

Equity Investment 100

Cash 100

When the firm you own the stake in earns a profit, you record your share of their profit on your Income
Statement and as an increase in the value of your investment:

Equity Investment 5
Equity Income (I/S-Income) 5

When they pay a dividend, you record the cash you receive and a reduction in the value of your
investment.

Cash 1
Equity Investment 1

Conceptually, your investment is a little like a savings account; the value increases by your share of the
profits on the investment (like the interest in a savings account) and decreases when they pay you a
dividend (like a withdrawal from a savings account).

Majority Ownership

When you buy the majority of another company, you typically buy it all. You record the purchase price
paid, the fair value of each of the assets you received and the fair value of liabilities you took on, and the
plug is goodwill.

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Imagine buying a company with the following assets and liabilities. The book values reflect the value of
the assets and liabilities on the target’s balance sheet. The fair values reflect, for example, the results of
an appraisal of the fair value of the identifiable assets and liabilities. Note that internally-developed
brands would not appear on the target’s balance sheet. We start by computing the value of the
Identifiable Assets of the firm and subtracting off the Liabilities.

Book Value Fair Value

Accounts Receivable 5 5
Inventory 8 9
Property, Plant and Equipment 7 10
Brands 0 8
Total Assets 20 32

Accounts Payable 4 4
Long-term Debt 11 12
Total Liabilities 15 16
Identifiable Assets – Liabilities 5 16

Suppose the acquirer paid $40 in the acquisition. They would be paying a substantial premium above
the value of the identifiable assets net of the liabilities. That is common in practice. If you were being
generous you would say they are willing to pay extra because of “synergies” between the target and the
acquirer. Accounting refers to that difference as Goodwill. In practice, it is the plug to make the journal
entry for the acquisition balance. The entry would be,

Accounts Receivable 5
Inventory 9
Property, Plant and Equipment 10
Brands 8
Goodwill (plug) 24
Accounts Payable 4
Long-term Debt 12
Cash (amount paid) 40

Note the following. First, each asset (and liability) is revalued to fair value. You don’t care about the
book value of the assets and liabilities on the acquired company’s books, just their fair values. Second,
intangibles such as brands that are acquired as part of the acquisition are included in the journal entry at
fair value because they are purchased intangibles. Third, the difference between the amount paid and
the fair value of the net assets acquired (in this case, $40 - $16 = $24) goes to Goodwill. Goodwill is a
purchased intangible which is not amortized but is tested for impairment (like all other assets).

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10.1: Accounting for marketable securities

The following are the events related to Ranj Corporation’s investments in marketable securities. The
securities are debt and pay interest on 6/30 and 12/31. The accounting period is the calendar year.

Security Acquisition Fair Value on 12/31:

Acquired Date Cost Yr, 1 Yr. 2 Date Sold Selling Price

Sec. A 6/30/Yr 1 $17.5 $18.0 $19.9 6/30/Yr 3 $19.1

Sec. B 6/30/Yr 1 $33.0 $23.2 $36.7 4/30/Yr 3 $28.0
Sec. C 6/30/Yr 1 $23.1 $24.0 - 3/31/Yr 2 $22.0

1. Prepare the journal entry for the receipt of interest on 6/30 and 12/31 of each year the security is
owned. Given that it would be the same journal entry every six months that the security is owned
and would be the same regardless of whether the security is treated as Trading, Available for Sale or
Held to Maturity, you only need to answer with one journal entry and don’t need to include numbers.

2. Prepare journal entries for the following events. First, assume that securities were Trading
Securities. Then, assume that the securities were Available for Sale Securities.

a) Acquisition of securities
b) Revaluation of securities at the end of the year
c) Sale of securities

TRADING SECURITIES

Security A:
6/30/Yr 1:

12/31/Yr 1:

12/31/Yr 2:

6/30/Yr 3:

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Security B:
6/30/Yr 1:

12/31/Yr 1:

12/31/Yr 2:

6/30/Yr 3:

Security C:
6/30/Yr 1:

12/31/Yr 1:

3/31/Yr 2:

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II. AVAILABLE FOR SALE SECURITIES
Security A:
6/30/Yr 1:

12/31/Yr 1:

12/31/Yr 2:

6/30/Yr 3:

Security B:
6/30/Yr 1:

12/31/Yr 1:

12/31/Yr 2:

6/30/Yr 3:

Security C:
6/30/Yr 1:

12/31/Yr 1:

3/31/Yr 2:

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3. Prepare journal entries for the following events assuming the securities were Held to Maturity (note
that interest was already accounted for in Part 1).

a) Acquisition of securities
b) Revaluation of securities at the end of the year
c) Repayment of principal

Security Acquisition Fair Value on 12/31:

Acquired Date Cost Yr. 2 Yr. 3 Date Repaid Principal
Sec. A 07/01/Yr.1 $17.5 $18.0 $19.9 6/30/Yr.4 $17.5

DEBT HELD TO MATURITY

6/30/Yr.1:

12/31/Yr.1:

12/31/Yr.2:

6/30/Yr.3

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