1. Introduction and Balance Sheet
   1. Accounting
      1. Accounting is a system for recording information about business transactions to provide summary statements of a company's financial position and performance to users who require such information
      2. Three sets of books
         1. Financial accounting
            1. Standardized reports for external stakeholders
         2. Tax accounting
            1. IRS rules for computing taxes payable
         3. Managerial accounting
            1. Custom reports for internal decision making
      3. Financial Reporting Requirements
         1. The Securities and Exchange Commission (SEC) requires periodic financial statement filings:
            1. 10-K: Annual report
            2. 10-Q: Quarterly report
            3. 8-K: Current report (material events)
            4. Must be prepared in accordance with Generally Accepted Accounting Principles (GAAP)
         2. Periodic filing requirements create much of the "tension" in financial accounting
            1. Ship goods to a customer in one quarter, collect cash in the next
            2. When did the sale occur?
            3. Buy equipment in one quarter, use it for the next 23 quarters
            4. When does the expense occur?
      4. Responsible for Financial Reporting
         1. Management is responsible for preparing financial statements
            1. The Audit Committee of the Board of Directors provides oversight of management's process
            2. Auditors are hired by the Board to "express an opinion" about whether the statements are prepared in conformity with GAAP
         2. The SEC and other regulators take action against the firm if any violations of GAAP or other rules are found
         3. Information intermediaries (stock analysts, institutional investors, the media) may expose or flee firms with questionable accounting
      5. Required Financial Statements
         1. Balance Sheet
            1. Financial position (listing of resources and obligations) on a specific date
         2. Income Statement
            1. Results of operations over a period of time using accrual accounting (i.e., recognition tied to business activities)
         3. Statement of Cash Flows
            1. Sources and uses of cash over a period of time
         4. Statement of Stockholders' Equity
            1. Changes in stockholders' equity over a period of time
      6. Example
         1. Dave's Car Transport Service
            1. Dave starts a business to transport expensive cars
            2. On December 1, 2015
            3. Receives $50,000 cash from issuing common stock
            4. Borrows $80,000 from bank and buys $100,000 truck
            5. Will be used for 48 mos., with a $4,000 salvage value
            6. Pays $12,000 cash upfront to rent office space for 1 year
            7. During December
            8. Moves two cars, will get paid $40,000 within 30 days
            9. Pays employees $10,000 of wages
            10. December 31: Bank wants to see financial statements
         2. Financial Statements
            1. Statement of Cash Flows
            2. Operating
            3. Rent (12,000)
            4. Wages (10,000)
            5. Customers 0
            6. CFO (22,000)
            7. Operating Activities: Transactions related to the provision of goods or services and other normal business activities
            8. Investing
            9. Truck (100,000)
            10. CFI (100,000)
            11. Investing Activities: Transactions related to the acquisition or disposal of long-lived productive assets
            12. Financing
            13. Stock 50,000
            14. Bank 80,000
            15. CFF 130,000
            16. Investing Activities: Transactions related to owners or creditors
            17. Cash 8,000
            18. Reports cash transactions over a period of time
            19. Income Statement
            20. Accounting Income
            21. Revenue 40,000
            22. Truck Expense (2,000)
            23. Rent Expense (1,000)
            24. Wages Expense (10,000)
            25. Net Income 27,000
            26. Expenses: Decreases in "owners' equity" incurred in the process of generating revenues
            27. Revenues: Increases in "owners' equity" from providing goods or services
            28. Net Income (or Earnings or Net Profit) = Revenues – Expenses
            29. Notes:
            30. Truck expense("depreciation") = (100,000 – 4,000)/48
            31. Rent expense is one month at $1000/mo
            32. Reports results of operations over a period of time using accrual accounting(权责发生制会计)
            33. Recognition tied to business activities
            34. DOES NOT EQUAL CHANGE IN CASH!!!
         3. Balance Sheet
            1. Assets
            2. Cash 8,000 (Cash in the bank on 12/31/2015)
            3. Accounts Receivable 40,000 (Cash owed by customers on 12/31/2015)
            4. Prepaid Rent 11,000 (Prepaid for 11 months of future space on 12/31/2015)
            5. Truck 98,000 (100,000 original cost – 2,000 "depreciation")
            6. Total 157,000
            7. Assets: Resources owned by a business that are expected to provide future economic benefits
            8. Liabilities & Stockholder's Equity
            9. Bank Debt 80,000 (Cash owed to the bank on 12/31/2015)
            10. Common Stock 50,000 (Stockholder investment as of 12/31/2015)
            11. Retained Earnings 27,000 (Accounting Net income – Dividends as of 12/31/2015)
            12. Total 157,000
            13. Liabilities: Claims on assets by "creditors" (non-owners) that represent an obligation to make future payment of cash, goods, or services
            14. Stockholders' Equity (Owners' Equity): Claims on assets by owners of business •Contributed Capital (arises from sale of shares) •Retained Earnings (arises from operations)
   2. Balance Sheet Equation (The Accounting Identity)
      1. Assets = Liabilities + Stockholders' equity
         1. Cash + Noncash assets = Liabilities + Contributed Capital + Retained Earnings
         2. Stockholders' Equity = Contributed Capital + Retained Earnings
         3. Retained Earnings = Prior Retained Earnings + Net Income – Dividends
         4. Net Income = Revenues – Expenses
         5. Assets = Liabilities + Contributed Capital + Prior Retained Earnings + Revenues – Expenses – Dividends
      2. Resources = Claims on Resources by Outsiders + Owners
      3. Key features
         1. Must always balance! (Double-entry bookkeeping)
         2. Changes over a period between two Balance Sheets are summarized in the Income Statement, Statement of Stockholders' Equity and Statement of Cash Flows
   3. Assets、Liabilities and Stockholders' equity
      1. Assets
         1. An asset is a resource that is expected to provide future economic benefits (i.e. generate future cash inflows or reduce future cash outflows)
         2. An asset is recognized when:
            1. It is acquired in a past transaction or exchange
            2. The value of its future benefits can be measured with a reasonable degree of precision
         3. Typical Current Assets
            1. Cash
            2. Marketable Securities (short-term, liquid investments)
            3. Accounts Receivable (amounts owed by customers on sales)
            4. Notes Receivable (amounts owed by noncustomers on loans)
            5. Interest Receivable (accrued revenue not yet received in cash)
            6. Inventory (costs of goods available for sale)
            7. Prepaid Expenses (rent, insurance, etc. – deferred expenses)
         4. Typical Long-Term Assets
            1. Land (tangible asset, not depreciated)
            2. Buildings, Equipment (tangible assets that are depreciated)
            3. Accumulated Depreciation (contra asset – sum of past depreciation)
            4. Investments (long-term investments)
            5. Notes Receivable (could also be noncurrent)
            6. Intangible assets (patents, goodwill, etc.)
      2. Liabilities
         1. A liability is a claim on assets by "creditors" (non-owners) that represents an obligation to make future payment of cash, goods, or services
         2. A liability is recognized when:
            1. The obligation is based on benefits or services received currently or in the past
            2. The amount and timing of payment is reasonably certain
         3. Typical Liabilities
            1. Accounts Payable (amounts owed to suppliers on purchases)
            2. Notes Payable (or mortgage payable – amounts owed to creditors [banks] on loans--could be current or noncurrent)
            3. Accrued Payables (or Accrued Expenses) (wages, salaries, interest, dividends, taxes, warranties, etc. – accrued expenses not yet paid in cash)
            4. Unearned Revenue (also advances from customers – deferred revenues)
      3. Stockholders' equity
         1. Stockholders' equity is the residual claim on assets after settling claims of creditors (= assets – liabilities) Also called "net worth", "net assets", "net book value"
         2. Sources of Stockholders' equity:
            1. Contributed capital (arises from sale of shares)
            2. Common stock (par value)
            3. Additional paid-in-capital (excess over par value)
            4. Treasury Stock (stock repurchased by company)
            5. Retained earnings (arises from operations)
            6. Accumulation of net income (revenues minus expenses), less dividends, since start of business
            7. Retained EarningsEND = Retained EarningsBEG + Net Income – Dividends
            8. Dividends are distributions of retained earnings to shareholders
            9. Not an expense
            10. Recorded as a reduction of retained earnings on the declaration date (creates a liability until payment date)
         3. Typical Stockholders' Equity
            1. Common Stock (at Par) (Shares issued times par value)
            2. Additional Paid-in-Capital (Shares issued times [market price – par value])
            3. Retained Earnings (Equals prior retained earnings plus revenues minus expenses minus dividends)
   4. Debit/Credit
      1. Three Fundamental Bookkeeping Equations
         1. Assets = Liabilities + Stockholders' Equity
         2. Sum of Debits = Sum of Credits
         3. Beginning account balance + Increases - Decreases = Ending account balance
         4. These equations must be in balance at all times! • The balance sheet equation can be preserved through the use of "debits" and "credits" • Definitions of Debit and Credit: – Debit (Dr.) = Left-side Entry – Credit (Cr.) = Right-side Entry
      2. Debit/Credit Bookkeeping
         1. Debits = Credits
         2. Rules of Debits and Credits:
            1. Every transaction must have at least one debit and at least one credit
            2. Debits must equal credits for all transactions
            3. No negative numbers are allowed
      3. Accounts and Account Balances
         1. Normal Balance
            1. The type of balance (debit or credit) the account carries under normal circumstances
         2. T Account
            1. A record of all changes in an accounting quantity
            2. Debits are listed on the left side of the T
            3. Credits are listed on the right side of the T
         3. Account Balance
            1. Difference between sum of debits and sum of credits for the account
         4. Change in Account Balance Equation:
            1. Beginning Balance + Increases - Decreases = Ending Balance
      4. Normal Balances and T-accounts
         1. Assets, Expenses
            1. Normal Balance is Debit (Left side of T)
            2. Increases through Debits (Left entries)
            3. Decreases through Credits (Right entries)
            4. Beginning (Debit) Balance + Debits - Credits = Ending (Debit) Balance
         2. Liabilities, Stockholders' Equity, Revenues
            1. Normal Balance is Credit (Right side of T)
            2. Decreases through Debits (Left entries)
            3. Increases through Credits (Right entries)
            4. Beginning (Credit) Balance + Credits - Debits = Ending (Credit) Balance
         3. Super T-account
      5. Analyzing Transactions & Journal Entries
         1. Three questions in analyzing transactions
            1. Which specific asset, liability, stockholders' equity, revenue or expense accounts does the transaction affect?
            2. Does the transaction increase or decrease the affected accounts?
            3. Should the accounts be debited or credited?
         2. Journal entry format
            1. Dr. <Name of Account Debited> $XXX Cr. <Name of Account Credited> $XXX
         3. Always list Debits first and always indent Credits
         4. Example
            1. BOC issues 10,000 shares of $5 par value stock for $15 cash per share Dr. Cash (+A) 150,000 Cr. Common Stock–Par (+SE) 50,000 Cr. Additional Paid in Capital (+SE) 100,000
            2. BOC acquires a building costing $500,000. It pays $80,000 cash and assumes a long-term mortgage for the balance of the purchase price Dr. Buildings (+A) 500,000 Cr. Cash (-A) 80,000 Cr. Mortgage Payable (+L) 420,000
            3. BOC obtains a 3-year fire insurance policy and pays the $3,000 premium in advance Dr. Prepaid Insurance (+A) 3,000 Cr. Cash (-A) 3,000
            4. BOC acquires on account office supplies costing $20,000 and merchandise inventory costing $35,000 Dr. Office Supplies (+A) 20,000 Dr. Inventory (+A) 35,000 Cr. Accounts Payable (+L) 55,000
            5. BOC pays $22,000 to its suppliers Dr. Accounts Payable (-L) 22,000 Cr. Cash (-A) 22,000
            6. BOC exchanges a building valued on the books at $200,000 for a piece of undeveloped land Dr. Land (+A) 200,000 Cr. Building (-A) 200,000
            7. BOC retires $1,000,000 of debt by issuing 100,000 shares of $5 par value stock Dr. Notes Payable (-L) 1,000,000 Cr. Common Stock–Par (+SE) 500,000 Cr. Additional Paid in Capital (+SE) 500,000
            8. BOC receives an order for $6,000 of merchandise to be shipped next month. The customer pays $600 at the time of placing the order Dr. Cash (+A) 600 Cr. Advances from Customers (+L) 600
            9. BOC declares and pays $8,000 of cash dividends Dr. Retained Earnings (-SE) 8,000 Cr. Cash (-A) 8,000
   5. Bookkeeping Examples
   6. The Accounting Cycle
2. Accrual Accounting and the Income Statement
   1. Revenues and Expenses
      1. Income Statement
         1. Reports increase in shareholders' equity due to operations over a period of time
         2. Income statement equation:
            1. Net Income = Revenue – Expenses
            2. Net income is also called "earnings" or "net profit"
         3. All income statement items are based on Accrual Accounting principles
      2. Accrual Accounting
         1. Accounting recognition of revenues and expenses are tied to business activities, not to cash flows
         2. Revenues are recognized when goods or services are provided (revenue recognition criteria) => Revenues ≠ Cash inflows
         3. Expenses are recognized in the same period as the revenues they helped to generate (matching principle) => Expenses ≠ Cash outflows
         4. Net income ≠ Net cash flow
      3. Revenue
         1. Revenue is an increase in shareholders' equity (not necessarily cash) from providing goods or services
         2. Revenue recognition criteria
            1. It is earned (i.e. goods or services are provided)
            2. It is realized (i.e. payment for goods or services received in cash or something that can be converted to a known amount of cash)
         3. Example
            1. BOC delivers $500,000 worth of washing machines in December to customers who don't have to pay until February $500,000
            2. BOC collects $300,000 cash in December for washing machines delivered in October $0
            3. BOC Realty leases space to a tenant for the months of December and January for $20,000, all of which is paid for in cash in December $10,000
            4. BOC Aerospace receives an order for a $400,000 jet in December to be delivered in July $0
            5. BOC Bank is owed $100,000 of interest on a loan for December and receives the payment in January $100,000
            6. BOC issues 20,000 shares of stock in December and receives $10/share, which is $2/share more than they expected $0
      4. Expenses
         1. Expenses are decreases in shareholders' equity (not necessarily cash) that arise in the process of generating revenues
         2. Expenses are recognized when either:
            1. Related revenues are recognized (product costs)
            2. Incurred, if difficult to match with revenues (period costs and unusual events)
         3. The underlying recognition concepts are the
            1. Matching principle (product vs. period costs)
            2. Conservatism principle (unusual events): recognize anticipated losses immediately, recognize anticipated gains only when realized
         4. Example
            1. BOC Automotive buys engines worth $2,000,000 in December for cash $0
            2. BOC Automotive uses the engines to make cars at a total cost of $10,000,000 in December $0
            3. BOC Automotive sells cars costing $8,000,000 in December for $15,000,000 $8,000,000
            4. BOC Automotive incurs $180,000 in salaries for its marketing staff in December $180,000
            5. BOC Automotive pays its auditor $50,000 in December for services to be rendered in December and January $25,000
            6. BOC Automotive pays $1,200,000 in cash dividends in December $0
   2. Adjusting Entries
      1. Adjusting entries
         1. Internal transactions that update account balances in accordance with accrual accounting prior to the preparation of financial statements
      2. Deferred Revenues and Expenses
         1. Update existing account balances to reflect current accounting values
         2. Cash flow in past; record revenue/expense now
         3. Deferred Expenses
            1. Question: Are there any assets that have been "used up" this period and should be expensed?
            2. Examples:
            3. Prepaid Rent
            4. Prepaid Insurance
            5. Depreciation or amortization
            6. Journal Entry:
            7. Dr. Expense Cr. Prepaid Asset
         4. Deferred Revenues
            1. Question: Are there any liabilities that have been fulfilled by delivery of goods or services that should be recognized as revenue?
            2. Examples:
            3. Unearned rental revenue
            4. Deferred subscription revenue
            5. Journal Entry:
            6. Dr. Unearned Revenue Liability Cr. Revenue
      3. Accrued Revenues and Expenses
         1. Create new account balances to reflect unrecorded assets or liabilities
         2. Record revenue/expense now; cash flow in future
         3. Accrued Expenses
            1. Question: Have any expenses accumulated during the period that have not yet been recorded?
            2. Examples:
            3. Income Taxes Payable
            4. Interest Payable
            5. Salaries and Wages Payable
            6. Journal Entry:
            7. Dr. Expense Cr. Payable Liability
         4. Accrued Revenue
            1. Question: Have any revenues accumulated during the period that have not yet been recorded?
            2. Examples:
            3. Interest Receivable
            4. Rent Receivable
            5. Journal Entry:
            6. Dr. Receivable Asset Cr. Revenue
      4. Depreciation and Amortization
         1. Allocate the original cost of a long-lived asset over its useful life
            1. Matches the total cost of asset to the revenues it generates over its period of use
         2. Terminology
            1. Tangible assets (physical assets) require depreciation
            2. Intangible assets (abstract assets) require amortization
         3. Accounting Procedure
            1. Depreciation is not deducted from the tangible asset account. Rather, it is recorded in a Contra Asset Account (XA) called Accumulated Depreciation, which
            2. has a credit balance
            3. is subtracted from PP&E on the balance sheet to get the "Net Book Value"
            4. Amortization is often (but not always) deducted directly from the intangible asset account
         4. Straight-line Depreciation:
            1. Depreciation expense = (Original Cost – Salvage Value) / Useful Life
      5. Super T-account
      6. Example
         1. September 30: BOC loans $100,000 to an employee at a 12% interest rate
            1. Dr. Notes Receivable (+A) 100,000 Cr. Cash (-A) 100,000
         2. December 31: End of the fiscal year, and no principal or interest payments have been made yet
            1. Dr. Interest Receivable (+A) 3,000 Cr. Interest Revenue (+R, +SE) 3,000
         3. January 6: The employee sends a check for three months of interest on the loan
            1. Dr. Cash (+A) 3,000 Cr. Interest Receivable (-A) 3,000
         4. December 31: End of the fiscal year. During December, employees earned $400,000 in salaries, but paychecks do not get issued until January 2
            1. Dr. Salary Expense (+E, -SE) 400,000 Cr. Salaries Payable (+L) 400,000
         5. January 2: The paychecks are sent
            1. Dr. Salaries Payable (-L) 400,000 Cr. Cash (-A) 400,000
         6. November 20: BOC pays $10,000 for December's rent
            1. Dr. Prepaid Rent (+A) 10,000 Cr. Cash (-A) 10,000
         7. December 31: End of the fiscal year. Is an adjusting entry needed? If so, what is it?
            1. Dr. Rent Expense (+E, -SE) 10,000 Cr. Prepaid Rent (-A) 10,000
         8. June 30: A customer pays BOC $60,000 for a three-year software license
            1. Dr. Cash (+A) 60,000 Cr. Unearned Software Revenue (+L) 60,000
         9. December 31: End of the fiscal year. Is an adjusting entry needed? If so, what is it?
            1. Dr. Unearned Software Revenue (-L) 10,000 Cr. Software revenue (+R, +SE) 10,000
         10. June 30: BOC purchases a building for $500,000. The expected life of the building is 20 years and its expected salvage value is $100,000
             1. Dr. Building (+A) 500,000 Cr. Cash (-A) 500,000
         11. December 31: End of the fiscal year: Is an adjusting entry needed? If so, what is it?
             1. Dr. Depreciation Expense (+E, -SE) 10,000 Cr. Accumulated Depreciation (+XA, -A) 10,000
             2. (500,000 – 100,000) / 20 = 20,000 annual expense 20,000 / 2 = 10,000 six-month expense
         12. December 31: BOC still has an outstanding order for $300,000 of products that will be delivered and billed in January
             1. No entry
      7. Overview of Adjusting Entries
   3. Preparation of Financial Statements
      1. Adjusted Trial Balance
         1. Summarizes balances in each account after adjusting entries
         2. Used to make financial statements
      2. Preparation of Financial Statements
         1. Prepare Income Statement first
         2. Then, use Net Income to update Retained Earnings and to prepare Balance Sheet
         3. Finally, complete the Statement of Cash Flows and Statement of Stockholders' Equity
      3. Income Statement Format
      4. Balance Sheet Format
         1. Assets are listed first in the following order:
            1. Current assets (benefits within next year)
            2. Ordered by liquidity (how readily can they be converted to cash)
            3. Cash
            4. Accounts Receivable
            5. Inventory
            6. Prepaid Assets
            7. Noncurrent assets
            8. Tangible assets
            9. Intangible assets
         2. Liabilities and Stockholders' Equity are listed next in the following order:
            1. Current liabilities (obligations within next year)
            2. Ordered by liquidity
            3. Bank borrowings
            4. Accounts payable and other payables
            5. Deferred revenues and other noncash
            6. Noncurrent liabilities
            7. Bank borrowings and bonds
            8. Other types of liabilities (deferred taxes, pensions)
            9. Stockholders' equity
            10. Contributed capital
            11. Retained earnings
   4. Close Temporary Accounts
      1. Temporary Accounts
         1. Accumulate the effects of transactions for a period of time only
         2. Revenue and Expense accounts
         3. Closed out to retained earnings at the end of period
      2. Permanent Accounts
         1. Accumulate the effects of transactions over the entire life of business
         2. Balance sheet accounts (Assets, Liabilities, Contributed Capital, Retained Earnings)
      3. Closing entries
         1. Internal transactions that "zero out" temporary accounts at the end of the accounting period
         2. Revenue and Expense account balances are transferred to Retained Earnings
            1. Revenues: Dr. Revenue Accounts (-R, -SE) Cr. Retained Earnings (+SE)
            2. Expenses: Dr. Retained Earnings (-SE) Cr. Expense Accounts (-E, +SE)
      4. Post-closing trial balance
         1. Summarizes balances of permanent accounts after closing entries
         2. All revenue and expense accounts have a zero balance
3. Cash Flows
   1. Statement of Cash Flows
      1. Reports changes in cash due to operating, investing, and financing activities over a period of time
      2. Statement of Cash Flows format:
      3. Non-cash transactions are disclosed at the bottom of the statement
      4. Cash interest paid and cash income taxes paid must also be disclosed
      5. Operating Activities
         1. Transactions related to providing goods and services to customers and to paying expenses related to generating revenue (i.e. "income statement" activities)
         2. Operating cash outflows exclude these income statement items:
            1. Depreciation and amortization (and other noncash items)
            2. Gains or losses on disposal of PP&E
      6. Investing Activities
         1. Transactions related to acquisition or disposal of long-term assets
      7. Financing Activities
         1. Transactions related to owners or creditors (except for interest payments)
      8. Note: Under IFRS, interest and dividends received and paid may be classified as operating, investing, or financing
      9. SCF and Growth Stages
   2. Methods for Preparing SCF
      1. Direct method
         1. Lists cash receipts and disbursements by source/use of funds
         2. Always used for investing and financing activities
         3. Rarely used for operating activities
      2. Indirect method
         1. Only used for operating activities
         2. Goal is to reconcile net income with cash from operations by removing noncash items from net income and including additional cash flows not in net income
         3. Almost every company uses this method for operating activities
      3. Indirect Method Preparation
         1. Start with Net Income
         2. Adjust for components of Net Income tied to noncash items or to investing activities
            1. Add back expenses or subtract revenues
            2. Noncash items: Depreciation, amortization
            3. Investing activities: Gains/losses on sale of PP&E or investments
         3. Adjust for components of Net Income tied to assets or liabilities created through operating activities (i.e., working capital)
            1. Add or subtract change in asset/liability account balance
            2. Use the balance sheet equation to determine whether to add or subtract:
            3. Cash + Noncash Assets = Liabilities + Owners' Equity
         4. Example of Direct vs. Indirect Method
   3. SCF Complications
      1. Why does the change in balance sheet numbers often not equal the number on the SCF?
         1. Noncash investing and financing activities
            1. Supplemental disclosure below SCF
         2. Acquisitions and divestitures of businesses
            1. Investing activity that affects balances in operating asset and liability accounts
         3. Foreign Currency Translation Adjustments
            1. Changes in cash due to exchange rate movements shown separately
         4. Subsidiaries in different industries (e.g. real estate)
            1. Some transactions (e.g. buying land) are investing activities in one part of business and operating in another
   4. Disagreement over FASB Classification
      1. Many investors and analysts prefer to classify
         1. Interest payments as a financing activity
            1. Cash paid for interest must be disclosed
         2. Interest and dividends received as an investment activity
      2. All income tax effects are shown in the operating section, even if the income relates to financing or investing activities
         1. Cash taxes must be disclosed
   5. EBITDA, Earnings, and Cash Flows
      1. EBITDA (Earnings before interest, taxes, depreciation, and amortization) is often used as a proxy for cash flow that excludes interest and taxes
         1. However, EBITDA does not measure cash flow well if there are large changes in working capital and suffers from the same manipulation potential as net income
         2. For example, "channel stuffing" would increase earnings and EBITDA, but no cash is collected (instead, accounts receivable increase). Subtracting the increase in AR from EBITDA would correct this problem
      2. Research finds that Earnings are a better predictor of future cash flow than current Cash Flow from Operations
         1. But using both gives the best predictions
   6. Free Cash Flow
      1. Operating cash flow minus cash for long-term investments
      2. There is no standard measure for operating cash flow. Examples for different textbooks include:
         1. Cash from operations before interest expense
         2. NOPLAT (Net operating profits less adjusted taxes)
            1. (NOPLAT = EBITDA – Cash taxes on EBITDA)
         3. NOPAT – increase in working capital
            1. (NOPAT = Net Income + After-tax net interest expense)
         4. Net income adjusted for depreciation and other noncash items – increase in working capital
         5. EBIT(1-tax rate) + Depreciation
         6. EBITDA
      3. Companies often disclose free cash flow using their own custom definition
   7. Purple Inc. & Green Co.
      1. Slides03-03-2.pdf
4. Relic Spotter Inc. Case
   1. Journal entries and post to T-accounts
      1. In March 2012, Rebecca Park identified an excellent business opportunity while she was a first-year MBA student at Wharton • She read a story about an MBA student who tripped while jogging in Fairmount Park and found an ancient gold coin in the underbrush. It was an old Viking coin that was appraised at $77,500 • She realized that she could set up a profitable business that rented out portable Metal Detectors to people that wanted to search Fairmount Park for more Viking relics • Also, Park had the idea of stocking her store with "sundries," such as water bottles and energy bars, that she could sell at a huge mark-up to renters before their expedition into the park Park prepared a business plan and approached a fellow student, Jay Girard, who had a sizable trust fund and who she believed would invest in this new venture • Due to his myriad of other investments, and his heavy course load, Girard agreed to invest as a silent partner and allow Park to run the business, which she named Relic Spotter Inc.
         1. (1) What accounts are involved?
         2. (2) Did they increase or decrease?
         3. (3) Do we debit or credit?
      2. (1) On April 1, 2012, Girard decided to invest $200,000 and Park put up $50,000 to purchase a total of 25,000 shares in the new company. The par value of the shares was $1.00
      3. (2) Lacking the funds for her initial investment, Park borrowed the $50,000 from the Imperial Bank of Philadelphia on April 1, using her parent's house as collateral
      4. (3) On April 2, Park hired a lawyer to have the business incorporated. Because this was a fairly simple organization, the legal fees were only $3,900
      5. (4) To house the business, Park bought an abandoned pizza parlor near Fairmount Park for $155,000 on April 7. The building was old and needed renovation work. The purchase documents allocated $103,000 to the land and $52,000 to the building. Park paid for the building with $31,000 cash and a $124,000 mortgage from the Imperial Bank
      6. (5) Park felt that some renovation work would extend the life of the building to 25 years (with an expected salvage value of $10,000). She ordered the renovation work, costing $33,000, to begin immediately. The work was completed on May 25, at which time she paid in cash the amount owed for the renovations
      7. (6) Park phoned a number of metal detector vendors until she found one that was willing to give her a volume discount. On June 2, Park purchased 240 metal detectors at an average cost of $500 per unit ($120,000 total). The innovation in the industry is so rapid that Park felt the units would only last for two years, at which time they would have no remaining value
      8. (7) On June 15, Park ordered $2,000 of sundries inventory (e.g., water bottles, energy bars, etc.) to be delivered on June 30. Park was able to purchase the inventory "on account", which meant she had up to 30 days after delivery to pay the supplier
      9. (8) On June 30, Park paid $2,100 for a three-year site license to use geo-contour mapping software in the metal detectors
      10. (9) On June 30, Park signed a contract with a local advertising agency to provide various forms of advertising for a period of one year. She paid $8,000 upfront for advertising through June 30, 2013
      11. (10) On June 30, Park needed cash to make a payment on the Imperial Bank loan that funded her purchase of Relic Spotter stock. She borrowed $5,000 from Relic Spotter at 10% interest, with the principal and interest due in a lump sum on June 30, 2013
      12. (11) On June 30, Park also hired two employees, Linda Carlyle and Charlotte Cafferly, to run the shop. They signed employment contracts promising each salaries of $32,000 per year
      13. (12) On June 30, Girard called from St. Tropez to check in on the business. Upon hearing that Relic Spotter only had $47,000 of cash left in the bank, Girard became concerned about his investment. Thinking fast, Park stated that she was so confident of Relic Spotter's prospects that she was declaring a $0.10 per share dividend, to be paid on August 31 ($2,500). This dividend seemed to reassure Girard
      14. (13) Relic Spotter opened for business on July 1, 2012, just in time for the big Independence Day weekend. On July 31, Park paid the supplier the $2,000 it was owed
      15. (14) On August 31, Park paid the $2,500 dividend that had been declared in June
      16. (15) In a search for new revenue opportunities, Park initiated an unlimited rental arrangement with the Penn Antiquities Club on December 1, 2012. Under this arrangement, the club paid Relic Spotter $1,200 cash upfront for unlimited rentals over the next year
      17. (16) For the six months ended December 31, 2012, rental revenues on the metal detectors totaled $124,300. Most of the rentals were paid in cash immediately. However, as an initiative to reward repeat customers, Park allowed a select number of frequent renters to charge their rentals and be billed later. As of December 31, 2012, $4,200 was outstanding under this plan
      18. (17) During the period between July 1 and December 31, Park purchased $40,000 of sundries inventory, of which $38,000 had been paid in cash and $2,000 was still owed at December 31
      19. (18) Relic Spotter recorded sales of sundries totaling $35,000 for the six months ended December 31, all received in cash
      20. (19) The original cost of these sundries was $30,000
      21. (20) Finally, Relic Spotter's two employees were paid wages of $32,000 total during this six-month period and Park drew a salary of $50,000
   2. Adjusting Entry
      1. (21) When Park called her accountant on December 31, 2012, she was pleased to tell him that the company had $78,800 in cash. She wanted to go out to celebrate, but the accountant reminded her that she needed to stay in to do adjusting entries. For example, even though it wasn't paid in cash, accrued interest on the mortgage was $4,900
      2. (22) The accountant said that depreciation needed to be recorded on the building (Park was confused by this because she received an unsolicited letter from a mortgage broker informing her that the building had increased in value to $120,000) Recall that, in transaction (5), Park renovated the building, bringing its original cost to $85,000. She also determined that the useful life of the building was 25 years, with an expected salvage value of $10,000
      3. (23) The accountant also noted that Park needed to record depreciation on the metal detectors Recall that, in transaction (6), Park purchased $120,000 of metal detectors. She determined that the units would only last for two years, at which time they would have no remaining value
      4. (24) The accountant continued…What about adjusting the software amortization account? Recall that, in transaction (8), Park paid the $2,100 three-year software license fee on June 30
      5. (25) …What about the prepaid advertising account? Recall that, in transaction (9), Park paid $8,000 upfront on June 30, 2012 for advertising through June 30, 2013
      6. (26) …What about the notes receivable account? Recall that, in transaction (10), Park borrowed $5,000 from Relic Spotter at 10% interest on June 30, 2012, with the principal and interest due in a lump sum on June 30, 2013
      7. (27) …What about the unearned revenue account? Recall that, in transaction (15), the Penn Antiquities Club paid Relic Spotter $1,200 cash upfront on December 1, 2012 for unlimited rentals over the next year
      8. (28) Finally, the accountant noted that Relic Spotter incurred an estimated income tax expense of $630 for 2012 (Park was also confused by this because she did not do her taxes until April)
   3. Statement of Cash Flows
      1. Transactions
         1. (1) Sell shares to investors
            1. Dr. Cash (+A) 250,000 Cr. Common Stock (+SE) 25,000 Cr. APIC (+SE) 225,000
         2. (3) Pay legal fees to incorporate the business
            1. Dr. Legal Fee Exp (+E, -SE) 3,900 Cr. Cash (-A) 3,900
         3. (4) Buy building and land
            1. Dr. Building (+A) 52,000 Dr. Land (+A) 103,000 Cr. Mortgage Payable (+L) 124,000 Cr. Cash (-A) 31,000
         4. (5) Pay for renovation work to building
            1. Dr. Building (+A) 33,000 Cr. Cash (-A) 33,000
         5. (6) Buy Metal Detectors
            1. Dr. Metal Detectors (+A) 120,000 Cr. Cash (-A) 120,000
         6. (8) Pay for a software site license
            1. Dr. Software (+A) 2,100 Cr. Cash (-A) 2,100
         7. (9) Prepay for advertising
            1. Dr. Prepaid Advertising (+A) 8,000 Cr. Cash (-A) 8,000
         8. (10) Lend money to Park
            1. Dr. Notes Receivable (+A) 5,000 Cr. Cash (-A) 5,000
         9. (13) Pay supplier
            1. Dr. Accounts Payable (-L) 2,000 Cr. Cash (-A) 2,000
         10. (14) Pay dividend
             1. Dr. Dividends Payable (-L) 2,500 Cr. Cash (-A) 2,500
         11. (15) Receive cash for future unlimited rentals
             1. Dr. Cash (+A) 1,200 Cr. Unearned Rental Rev (+L) 1,200
         12. (16) Receive cash rental revenue on the Metal Detectors
             1. Dr. Cash (+A) 120,100 Dr. Accounts Receivable (+A) 4,200 Cr. Rental Rev. (+R, +SE) 124,300
         13. (17) Pay for inventory
             1. Dr. Inventory (+A) 40,000 Cr. Cash (-A) 38,000 Cr. Accounts Payable (+L) 2,000
         14. (18) Receive cash from sales of sundries
             1. Dr. Cash (+A) 35,000 Cr. Sales (+R, +SE) 35,000
         15. (20) Pay employee wages
             1. Dr. Sal & Wage Exp (+E, -SE) 82,000 Cr. Cash (-A) 82,000
      2. Income Statement
      3. Balance Sheet
      4. Direct Method
         1. Investing Activities
         2. Financing Activities
         3. Operating Activities
      5. Indirect Method
         1. Operating Activities
5. Working Capital Assets
   1. Recognizing Uncollectible Accounts
      1. Direct write-off method
         1. Recognize expense when account deemed uncollectible
         2. Used for tax reporting, not allowed under GAAP
      2. Allowance methods
         1. Required under GAAP for financial reporting
         2. Recognize Bad Debt Expense for estimated future uncollectible amounts from sales during the period
         3. Create an Allowance for Doubtful Accounts (XA) to offset Accounts Receivable on the balance sheet
      3. Net Accounts Receivable = (Gross) Accounts Receivable – Allowance for Doubtful Accounts (XA)
      4. Example:
         1. BOC makes $10 in sales on account to each of three customers: Jordan, Dakota, and Peyton
         2. At end of period, BOC estimates that $10 of sales will not be collected
         3. In the next period, BOC collects from Jordan and Peyton
         4. After 90 days, BOC gives up on collecting from Dakota and writes-off the receivable
         5. Final Totals: $20 of Cash and $20 of Pre-Tax Income
         6. What if Dakota later pays us? After the write-off, Dakota wins the lottery and pays us $10
   2. Estimating Uncollectible Accounts
      1. Two Allowance Methods
         1. Percentage-of-sales method
            1. Estimates Bad Debt Expense directly
            2. Multiply (credit) sales by an estimated uncollectible percentage to compute Bad Debt Expense
            3. Plug in T-account to solve for the ending balance of Allowance for Doubtful Accounts
            4. Example: BOC had credit sales of $75,000 during the quarter BOC estimates that 2% of credit sales will be uncollectible
            5. Bad Debt Expense = Credit Sales X Estimated Uncollectible Pct.
            6. Bad Debt Expense = 75,000 X 0.02
            7. Bad Debt Expense = 1,500
         2. Aging-of-accounts-receivable method
            1. Estimates ending balance of Allowance for Doubtful Accounts directly
            2. Multiply balance sheet A/R amounts by estimated uncollectible percentages (based on how long the A/R has been outstanding) to compute ending balance of Allowance for Doubtful Accounts
            3. Plug in T-account to solve for Bad Debt Expense
            4. Expamle: BOC has $15,000 of Accounts Receivable at the end of the quarter BOC groups the A/R by age (i.e., time outstanding)
            5. BOC estimates an uncollectible percentage for each age group and computes a necessary allowance for each age group
            6. The sum of the allowances is the ending balance in Allowance for Doubtful Accounts
      2. A/R and the SCF
         1. Cash flow effects of A/R
            1. Cash collections of A/R are operating cash flows
            2. Bad Debt Expense, Write-offs, and Recoveries are NONCASH transactions
         2. Two methods for Bad Debt Expense and the Indirect Method
            1. Add back Bad Debt Expense (net of write-offs and recoveries) Add or subtract change in Gross A/R
            2. Add or subtract change in Net A/R (A/R net of noncash amounts)
      3. Collecting cash from Accounts Receivable more quickly
         1. Pledging
            1. Use A/R as collateral for a loan. The firm retains the A/R and the risk of collection
         2. Factoring
            1. Sell A/R to a financial institution at a discount that reflects an interest charge and the risk of uncollectibility
         3. Securitization
            1. Selling A/R to a separate legal entity (called a Variable Interest Entity) created for the exclusive purpose of securitizing receivables. The VIE borrows money from investors and then uses the proceeds to buy the A/R from its parent
   3. Disclosure example
      1. TK Inc. sells coin wrappers to the banking industry Sales for the year ended Dec. 31, 2008 were $149,270
      2. What were write-offs of A/R in 2008?
         1. Write-offs = 220 + 1558 – 1021 = 757
      3. What were cash collections from customers in 2008?
         1. Collections = 8,046 + 149,270 – 757 – 13,951 = 142,608
         2. Note that difference between Sales and Collections is 6,662 (149,270 – 142,608)
      4. By how much did a change in the estimated uncollectible percentage affect bad debt expense in 2008?
         1. Compute the percentage of Gross Accounts Receivable that are expected to be uncollectible accounts in prior year
            1. Percent uncollectible = Allowance / (Net AR + Allowance)
         2. Apply this percentage to balance of Gross Accounts Receivable in current year to get expected balance
            1. Expected balance of Allowance = Percent uncollectible * (Net AR + Allowance)
         3. Change in expense due to change in bad debt assumptions is the actual balance in Allowance minus expected balance
      5. Credit Sales and Sales Revenue
   4. Inventory
      1. Inventory Cost Flows for a Retail Firm
      2. Inventory Cost Flows for a Manufacturing Firm
         1. Kirby Manufacturing Inc. Example:
            1. (1) Kirby purchased $865 of raw materials on account
            2. Journal Entry (1) Dr. Raw Materials (+A) 865 Cr. Accounts Payable (+L) 865
            3. (2) Kirby used $806 of raw materials inventory in manufacturing
            4. Journal Entry (2) Dr. Work in Process (+A) 806 Cr. Raw Materials (-A) 806
            5. (3) Kirby paid $524 cash for manufacturing labor (4) Kirby paid $423 cash for power, heat, light, and other overhead (5) Kirby recognized $81 of depreciation for plant equipment
            6. Journal Entries (3) Dr. Work in Process (+A) 524 Cr. Cash (-A) 524 (4) Dr. Work in Process (+A) 423 Cr. Cash (-A) 423 (5) Dr. Work in Process (+A) 81 Cr. Accumulated Depreciation (+XA) 81
            7. (6) Kirby finished manufacturing goods that cost $1,960
            8. Journal Entry (6) Dr. Finished Goods (+A) 1,960 Cr. Work in Process (-A) 1,960
            9. (7) Kirby sold $2,862 of goods to customers on account (8) The goods cost $1,938 to manufacture
            10. Journal Entries (7) Dr. Accounts Receivable (+A) 2,862 Cr. Sales (+R, +SE) 2,862 (8) Dr. Cost of Goods Sold (+E, -SE) 1,938 Cr. Finished Goods (-A) 1,938
      3. Inventory and COGS
         1. New Inventory
            1. Retail firms: New Inventory is cost of purchasing goods
            2. Manufacturing firms: New Inventory is cost of producing goods
         2. Inventory/COGS computation methods
            1. Periodic system
            2. Count Ending Inventory and plug COGS
            3. Perpetual system
            4. Track COGS as sales are made and plug Ending Inventory
      4. Inventory Valuation: Lower-of-Cost-or-Market
         1. Ending Balance of Inventory must be carried at the lower of historical cost or fair market value
            1. Historical Cost is the original cost of purchasing or producing the inventory
            2. Fair Market Value generally is the replacement cost of the inventory
         2. If Historical Cost ≤ FMV, Ending Inventory = Original Cost
            1. No adjusting entry needed
         3. If FMV < Historical Cost, Ending inventory = Replacement Value
            1. Need an adjusting entry to write-down inventory from original to replacement cost
            2. Dr. COGS (+E, -SE) Cr. Inventory (-A)
         4. Key international difference
            1. Under U.S. GAAP, once inventory is written down to FMV, it cannot be later written back up to original cost if the market value subsequently rises
            2. Under IFRS, inventory can be written up subsequent to a write-down, but only back up to the original cost
   5. FIFO vs. LIFO
      1. Inventory Cost Flow Assumptions
         1. KEY POINT: Inventory cost flows do NOT have to follow physical flow of goods
         2. Physical flow of goods:
            1. Goods in Ending inventory are whatever specific goods that we haven't sold yet
         3. Flow of costs:
            1. Costs in Ending Inventory could (1) match the original cost of the goods, (2) be the most recent costs incurred, (3) be the oldest costs incurred, or (4) be an average of costs over time
         4. Specific identification
            1. Specifically identify cost of each product sold
         5. FIFO (First-In, First-Out)
            1. Oldest inventory costs go in COGS first
            2. => Ending inventory has newest costs
         6. LIFO (Last-In, First-Out)
            1. Newest inventory costs go in COGS first
            2. => Ending inventory has oldest costs
         7. Weighted average
            1. Average cost of all inventory goes into COGS and ending inventory
      2. Basic LIFO/FIFO Example
         1. The low LIFO COGS in 2012 is due to dipping into old "LIFO layers" of inventory.
         2. This is called a "LIFO liquidation" and must be disclosed due to its dramatic effect on COGS and Net Income.
         3. LIFO v. FIFO changes the timing of COGS, but over the life of the firm, total COGS are the same
      3. Why does it matter whether firms use FIFO or LIFO?
         1. When inventory costs are rising, COGS under LIFO is higher and Ending Inventory under LIFO is lower as compared to FIFO
         2. KEY: Tax reporting in US allows LIFO
            1. High LIFO COGS => Lower Taxable Income => Lower Taxes Paid!
            2. But, if firms use LIFO for taxes, must use LIFO for financial statements
         3. IFRS does not permit the use of LIFO
            1. US is only major country that still allows LIFO
   6. Inventory Disclosure Example
      1. Comparing LIFO and FIFO firms
         1. LIFO firms must also disclose FIFO inventory costs
            1. We can convert LIFO to FIFO, but we can't convert FIFO to LIFO
         2. LIFO Reserve = FIFO End Inventory – LIFO End Inventory
         3. Δ LIFO Reserve = LIFO COGS – FIFO COGS
            1. FIFO COGS = LIFO COGS – Δ LIFO Reserve
         4. FIFO Net Income = LIFO Net Income + [Δ LIFO Reserve * (1 – tax rate)]
            1. Tax savings (current year) = Δ LIFO Reserve * tax rate
            2. Tax savings (cumulative) = LIFO Reserve * tax rate
      2. LIFO Disclosure Example: KP Inc. manufactures flux capacitors KP uses the LIFO method COGS for KP are $1855 during 2012 KP's tax rate is 35%
         1. What is the FIFO value of the inventory?
            1. FIFO Inv = LIFO Inv + LIFO Reserve
            2. FIFO Inv = 518 + 102 = 620 in 2012
            3. FIFO Inv = 540 + 63 = 603 in 2011
         2. What would be FIFO COGS in 2012?
            1. FIFO COGS = LIFO COGS - Δ LIFO Reserve
            2. FIFO COGS = 1855 - (102 – 63)
            3. FIFO COGS = 1816
         3. What were 2012 tax savings?
            1. Tax Savings = Δ LIFO Reserve * 35%
            2. Tax Savings = (102 – 63) * 0.35
            3. Tax Savings = 13.65
6. Ratio Analysis
   1. Misusing ratios
      1. Standard ratios have multiple definitions
         1. There is no GAAP for ratio definitions
         2. Use the same definition to make valid comparisons
      2. Choosing the appropriate benchmark for comparison is important
         1. Major changes in the firm distort time-series analysis
         2. Differences in business strategy, capital structure, or business segments distort cross-sectional analysis
         3. Differences in accounting methods make all comparisons difficult
      3. Ratios may be manipulated by managerial action
   2. Return on Equity
      1. Return on Equity (ROE)
         1. ROE = Net Income / Average Shareholders' Equity
         2. The numerator represents how much return the company generated for shareholders during the year based on accrual accounting
         3. The denominator represents the shareholders' investment in the company
            1. Must take average of beginning and ending balances
         4. Measures Return on Investment (ROI)
            1. Should increase with the risk of the company
      2. Two Drivers of ROE
         1. Operating performance
            1. How effectively do managers use company resources (assets) to generate profits?
            2. Return on Assets (ROA)
            3. ROA = Net Income/Average Assets
         2. Financial leverage
            1. How much do the managers use debt to increase available assets for a given level of shareholder investment?
            2. Financial leverage = Avg. Assets/Avg. Shareholders' Equity
            3. Note that this is different from many "leverage" ratios you hear about (e.g., debtto-equity)
      3. ROE Framework
         1. Example: Company raises $100 from shareholders and borrows $100 from bank to buy $200 of assets, which are used to generate $10 of net income
         2. ROE = 10% (10/100), ROA = 5% (10/200), Leverage = 2 (200/100) => 10% = 5% x 2
   3. Return on Assets
      1. Two drivers of Return on Assets
         1. Profitability
            1. How much profit does the company earn on each dollar of sales?
            2. Return on Sales (ROS)
            3. ROS = Net Income/Sales
         2. Efficiency
            1. How much sales does the company generate based on its available resources?
            2. Asset Turnover
            3. ATO = Sales/Avg. Assets
      2. ROA and Leverage
         1. Ideally, ROA would measure operating performance independent of the company's financing decisions
         2. But, the numerator of ROA, Net Income, includes Interest Expense
            1. More leverage => higher Interest Expense => lower Net Income
         3. To truly remove all financing effects from ROA, we must de-lever Net Income
         4. ROA = De-Levered Net Income / Avg. Assets
         5. De-levered Net Income = Net Income + (1-t) x Interest Expense
      3. ROA Example
   4. Common Size Financial Statements
      1. Hard to spot trends in the financial statements because of growth
         1. Growth in Assets and Sales drive trends in all of the line items
         2. Are certain line items growing more or less than would be expected given the growth in assets or sales?
      2. Balance sheet
         1. Express all numbers as a percent of Total Assets
      3. Income statement
         1. Express all numbers as a percent of Sales
      4. Cash flow statement
         1. Typically not common sized
   5. DuPont Analysis
      1. DuPont Ratio Analysis Framework
      2. Profit Margin Ratios
         1. Profit Margin Ratios
            1. What are the drivers of profitability (or lack of profitability)?
            2. Use Common Size income statement for most of these
            3. Gross Margin = (Sales - Cost of Goods Sold) / Sales
            4. SG&A-to-Sales = SG&A Expense / Sales
            5. Operating Margin = Operating Income / Sales
            6. Interest Expense-to-Sales = Interest Expense / Sales
            7. Effective Tax Rate = Income Taxes / Pre-tax Income
      3. Asset Turnover Analysis
         1. Asset Turnover Ratios
            1. How many times per year do we cycle through accounts?
            2. Example: Inventory Turnover of 8 means that we build and sell Inventory 8 times per year, on average.
            3. Accounts Receivable Turnover = Sales / Average A/R
            4. Inventory Turnover = Cost of Goods Sold / Average Inventory
            5. Accounts Payable Turnover = Purchases / Average Accounts Payable
            6. (Purchases = Ending Inventory + COGS – Beginning Inventory)
            7. Fixed Asset Turnover = Sales / Avg. Net PP&E
         2. Days Outstanding Ratios
            1. How many days, on average, are accounts outstanding?
            2. Example: Days Inventory of 45 means that it takes 45 days, on average, from the time we start building Inventory until we sell it
            3. Days Receivable (Sales) Outstanding = 365 / A/R Turnover
            4. Days Inventory = 365 / Inventory Turnover
            5. Days Payable = 365 / A/P Turnover
            6. Net Trade Cycle = Days Receivable + Days Inventory - Days Payable
            7. Net Trade Cycle represents the gap between cash outflows and cash inflows that we have to bridge with short-term borrowing
   6. Liquidity Ratio Analysis
      1. Common Liquidity Ratios
      2. Short-Term Liquidity Ratios
         1. Does the company have enough cash coming in to cover obligations to pay out cash?
            1. Ideally, ratios would be over 1
         2. Current Ratio = Current Assets / Current Liabilities
         3. Quick Ratio = (Cash + Receivables) / Current Liabilities
         4. CFO to Current Liabilities = Cash from Operations / Avg. Current Liabilities
      3. Interest Coverage Ratios
         1. Does the company have enough cash coming in from operations to cover interest obligations?
            1. Ideally, ratios would be over 1
         2. Interest Coverage = (Operating Income before Depreciation) / Interest Expense
         3. Cash Interest Coverage = (Cash from Operations + Cash Interest Paid + Cash Taxes) / Cash Interest Paid
      4. Long Term Debt Ratios
         1. How does the company finance its growth?
            1. Also provide measure of bankruptcy risk
         2. Debt to Equity = Total Liabilities / Shareholders' Equity
            1. Total Assets is sometimes used in the denominator
         3. Long-Term-Debt to Equity = Total Long-Term Debt / Total Stockholders' Equity
         4. Long-Term Debt to Tangible Assets = Total Long-Term Debt / (Total Assets - Intangible Assets)
   7. Plainview Technology Case
      1. Background
         1. Plainview manufactures iris scanning equipment for biometric identification
         2. In 2009, Plainview lost its largest customer, a defense contractor, which accounted for half of its business
            1. Customer transferred business to a foreign competitor with lower labor costs
         3. Plainview management responded by increasing automation
            1. Also built plants in California and South Carolina to be closer to customers
         4. Plainview expanded into new industries
            1. Health care, financial institutions, nuclear power
         5. Plainview switched from high-volume, standard products to smallerbatch, customized products
         6. In 2010, Plainview adopted new 6G technology, which provides better results at lower manufacturing cost
         7. The company has experienced explosive growth after surviving its crisis and has picked up greater following by analysts and investors
         8. A new analyst has just a few hours to prepare before participating on a conference call with Plainview Technology management
         9. Only information available is financial statements and ratios
         10. Based on the ratios, what seems to be the secret to the company'sturnaround?
         11. What questions would you ask management during the call?
      2. Common Size Financial Statements
      3. DuPont Analysis
         1. Return on Equity = Net Income / Avg. Stockholders' Equity
         2. Return on Assets = (Net Income + After-tax Interest Exp.) / Avg. Total Assets
         3. Financial Leverage = Avg. Total Assets / Avg. Stockholders' Equity
         4. Return on Sales = (Net Income + After-tax Interest Exp.) / Sales
         5. Asset turnover = Sales / Avg. Total Assets
         6. Cross-Sectional Comparisons
         7. DuPont Analysis Conclusions
            1. Big increases in ROE were unique for the industry
            2. Improved ROA was the source of the increase in ROE
            3. Financial Leverage was largely unchanged
            4. The ultimate source of the ROE increase was improvement in Profit Margin (Return on Sales)
            5. In contrast to competitors, ROS grew dramatically
            6. Asset Turnover ratio was flat (similar to competitors)
            7. => The secret to Plainview's success was that their sales became more profitable between 2009 and 2011
         8. Profit Margin Analysis
            1. Gross Margin = (Sales - Cost of Goods Sold) / Sales
            2. SG&A as a % of Sales = SG&A Expense / Sales
            3. Operating Margin = Operating Income / Sales
            4. Interest Expense as % of Sales = Interest Expense / Sales
            5. Effective Tax Rate = Income Taxes / Pre-tax Income
            6. Profit Margin Analysis Questions
            7. Possible explanations for improvement in gross margin:
            8. Reducing production costs while maintaining sales price
            9. Did Plainview further automate its production?
            10. Raising sales price while keeping costs constant
            11. Did entry into new markets allow a higher mark-up?
            12. => Search for confirming or disconfirming evidence of these explanations
            13. => Ask management to explain the source of the dramatic improvement in product mark-up
         9. Asset Turnover Analysis
            1. For example, dramatic increases in Sales are often accompanied by
            2. Lower Inventory levels
            3. Production can barely keep up with sales
            4. Higher Accounts Receivable levels
            5. Company has to extend credit to riskier customers to fuel sales growth
            6. Although Asset Turnover ratio was steady over the period, looking at the detailed components of the ratio may provide further insight into how Plainview managed its remarkable turn-around
            7. Asset Turnover Ratios
            8. Accounts Receivables Turnover = Sales / Avg. Accounts Receivable
            9. Inventory Turnover = Cost of Goods Sold / Avg. Inventory
            10. Accounts Payable Turnover = Purchases / Avg. Accounts Payable
            11. (Purchases = Ending Inventory + COGS – Beginning Inventory)
            12. Fixed Asset Turnover = Sales / Avg. Net Property, Plant and Equipment
            13. Days Outstanding Ratios
            14. Days Receivables = 365 * (Avg. Accounts Receivable / Sales)
            15. Days Inventory = 365 * (Avg. Inventory / Cost of Goods Sold)
            16. Days Payable = 365 * (Avg. Accounts Payable / Purchases)
            17. (Purchases = Ending Inventory + COGS – Beginning Inventory)
            18. Net Trade Cycle = Days Receivable + Days Inventory - Days Payable
            19. Cross-Sectional Comparisons
            20. Conclusions from the Ratio Analysis
            21. Overall, ratio analysis suggests:
            22. Entry into new markets produces higher-margin sales with faster collections, but longer production times
            23. But, how can they do this with 40%+ sales growth?
            24. And why do they have volatile cash flows from operations?
      4. Liquidity Ratio Analysis
         1. Short-term Liquidity Ratios
            1. Current Ratio = Current Assets / Current Liabilities
            2. Quick Ratio = (Cash + Accts Rec) / Current Liabilities
            3. CFO-to-Current Liabilities = Cash from Operations / Avg. Current Liabilities
         2. Interest Coverage Ratios
            1. Interest Coverage = (Operating Income before Depreciation) / Interest Expense
            2. Cash Interest Coverage = (Cash from Operations + Cash Interest +Cash Taxes) / Cash Interest Paid
         3. Long Term Debt Ratios
            1. Debt to Equity = Total Liabilities / Shareholders' Equity
            2. Long-Term-Debt to Equity = Total Long-Term Debt / Total Stockholders' Equity
            3. Long-Term Debt to Tangible Assets = Total Long-Term Debt / (Total Assets - Intangible Assets)
         4. Liquidity Ratio Conclusions
            1. Plainview is in a strong short-term cash position
            2. Quick ratio over 1
            3. High interest coverage ratios
            4. Plainview has managed its leverage well through its expansion
            5. Small increases in debt-to-equity and LTD-to-Tangible Assets ratios
            6. Liquidity is not a major concern for Plainview
7. Long-lived Assets and Marketable Securities
   1. Tangible Asset
      1. Long-Lived Assets
         1. An Asset that will provide benefits for more than one year
            1. Tangible Assets: Property, Plant, and Equipment
            2. Intangible Assets: Goodwill, Brand Names, Patents, Customer Lists
         2. Accounting issues
            1. Acquisition cost
            2. Depreciation and amortization
            3. Ongoing costs
            4. Disposals
            5. Impairments
      2. Capitalizing vs. Expensing
         1. Capitalizing
            1. When costs incurred (yr 1) Dr. Asset 100 Cr. Cash or payable 100
            2. Future entries (yr 1 – yr 10) Dr. Expense 10 Cr. Asset 10
            3. Total expense over 10 years = 100
         2. Expensing
            1. When costs incurred (yr 1) Dr. Expense 100 Cr. Cash or payable 100
            2. Future entries (yr 1 – yr 10) No entry
            3. Total expense over 10 years = 100
      3. Acquisition Costs for Long-Lived Assets
         1. Capitalize all costs necessary to get an asset ready for its intended use (e.g., purchase price, delivery charges, installation costs, etc.)
         2. For self-constructed assets, also capitalize interest on debt that is incurred to finance the asset's construction
            1. In this case, interest expense on the income statement does not reflect all of the interest costs incurred by the firm
         3. If acquisition costs include multiple classes of assets (e.g. land, building, and machinery), the cost must be allocated into separate asset classes
         4. Example
            1. (1) Bott Inc. builds a new piece of equipment to put grips on golf clubs. Bott spends $4,500 cash on raw materials and $3,000 cash on labor. Bott incurs $500 of interest costs (interest payable) to finance the building of the equipment
            2. (1) Dr. Equipment (+A) 8000 Cr. Cash (-A) 7500 Cr. Interest Payable (+L) 500
      4. Depreciation and Amortization
         1. Terminology
            1. Tangible assets (Buildings and equipment) are depreciated
            2. Intangible assets (Patents, Software) are amortized
         2. Elements of depreciation calculations
            1. Depreciable basis (acquisition cost – salvage value)
            2. Useful life (years or units)
            3. Depreciation pattern (straight-line or accelerated)
         3. All of these elements are chosen by management
         4. Depreciation Methods
            1. Straight line (most common in financial statements)
            2. Depreciation Expense = (Acquisition Cost – Salvage Value) / Useful life
            3. Accelerated (almost never used in financial statements)
            4. Double declining balance
            5. Depreciation exp = (Cost – Acm. Depr.) * (2 / Useful life)
            6. Sum-of-the-Years digits
            7. Depreciation exp = (Cost – Salvage) * (Remaining life / Sum-of-the-Years Digits)
            8. MACRS (required in U.S. tax returns)
            9. Call your tax accountant for details…
            10. Firms can use different methods for taxes and financial statements
            11. Total depreciation expense is the same over the life of the asset, regardless of method used
            12. Depreciation Patterns
            13. Example
            14. Bott management decides that the equipment will have a useful life of six years with a $2,000 salvage value. Bott must recognize one year of depreciation using the straight-line method
            15. Annual Depreciation = (Acquisition Cost – Salvage Value) / Useful Life
            16. Annual Depreciation = (8000 – 2000) / 6
            17. Annual Depreciation = 1000
            18. (2) Bott management estimates that 3/4 of the time the equipment was used to produce golf club inventory; the rest of the time it was used for the personal clubs of the sales force and top management (which is a perk that Bott provides these employees)
            19. (2) Dr. Work-in-Process (+A) 750 Dr. Depreciation Expense (+E) 250 Cr. Accumulated Depreciation (+XA) 1000
      5. Ongoing Costs for Long-lived Assets
         1. Expense costs when they are related to the maintenance of an asset
         2. Capitalize costs when they:
            1. Increase the useful life of the asset or
            2. Increase the value of the asset
         3. These capitalized costs will add to future depreciation expense
            1. Also, adjust useful life and salvage value assumptions if necessary
            2. Recompute depreciation expense going forward
            3. Use Net Book Value as new historical cost of asset
         4. Example
            1. (3) Bott spends $200 on routine maintenance for the equipment
            2. (3) Dr. Maintenance Expense (+E) 200 Cr. Cash (-A) 200
            3. (Note: this Maintenance Expense will be split between Work-in-Process Inventory [75%] and SG&A Expense [25%])
            4. (4) Bott spends $600 on new attachment to the equipment that will allow it to add grips to the new style of extra-long putter
            5. (4) Dr. Equipment (+A) 600 Cr. Cash (-A) 600
            6. Bott management decides that the new attachment has increased the useful life to ten years (going forward) with salvage value of $600. Bott must recognize one more year of depreciation
            7. Annual Depreciation = (Net Book Value – Salvage Value) / Useful Life
            8. Annual Depreciation = (7600 – 600) / 10
            9. Annual Depreciation = 700
            10. (5) Bott management estimates that 100% of the time the equipment was used to produce golf club inventory (much to the dismay of its employees with extra-long putters)
            11. (5) Dr. Work-in-Process (+A) 700 Cr. Accumulated Depreciation (+XA) 700
      6. Disposal of PP&E
         1. Historical cost of asset is removed from PP&E account and all related depreciation is removed from Accumulated Depreciation
         2. Gain or loss on the sale of PPE is recorded when the proceeds from disposal are more or less than the net book value, respectively
            1. Net book value = historical cost – accumulated depreciation
         3. Dr. Cash (+A) (sale amount) Dr. Accumulated Depreciation (-XA) (full balance) Dr. Loss on sale (+E) (plug if Net Book Value > Cash) Cr. Gain on sale (+R) (plug if Net Book Value < Cash) Cr. Specific PP&E Account (-A) (historical cost)
         4. Example
            1. Bott is in financial distress due to high employee turnover. Bott decides to subcontract the grip work, so it sells its piece of equipment for $5,500
            2. (6) Dr. Cash (+A) 5500 Dr. Accumulated Depreciation (-XA) 1700 Dr. Loss on Sale (+E) 1400 ((8600-1700) – 5500) Cr. Equipment (-A) 8600
      7. Impairment Tests
         1. Long-lived assets must be written down if they fail an impairment test
            1. Step 1: Have circumstances changed that raise the possibility of an impairment?
            2. Step 2: Are the future undiscounted net cash flows from the asset (from use or sale) less than its net book value?
            3. Step 3: Write-down the book value of the asset (and record a loss) equal to the difference between the fair value of the asset and its net book value
            4. Note that discounted cash flows are used to compute fair value in Step 3!
         2. Example
            1. (6) In an alternate reality, Bott keeps the equipment but finds that it has been impaired due to employee sabotage. Bott management estimates that the fair market value of the equipment is now $5,500
            2. (6) Dr. Equipment (+A) 5500 Dr. Accumulated Depreciation (-XA) 1700 Dr. Impairment Loss (+E) 1400 ((8600 – 1700) – 5500) Cr. Equipment (-A) 8600
      8. International Differences for Long-Lived Assets
         1. Carrying value
            1. US GAAP: requires the lower-of-cost-or-market with depreciation expense recorded each period
            2. IFRS: allows lower-of-cost-or-market method or fair value method. Under fair value method, PP&E is carried at fair value at all times, with any unrealized gains or losses either flowing through the income statement or directly to stockholders' equity
         2. Impairments
            1. U.S. GAAP: Assets written down cannot be written back up in value at a later date
            2. IFRS: Under lower-of-cost-or-market, assets written down can be written back up to the original cost of the asset (less accumulated depreciation). Also, determination of whether an impairment is necessary is initially based on the discounted present value of cash flows
   2. Intangible Assets
      1. In general, US GAAP and IFRS require:
         1. Internally-developed intangibles to be expensed immediately
            1. R&D, Advertising, Employee Training
            2. Some types of R&D can be capitalized
            3. US GAAP: Software
            4. IFRS: Development
         2. Purchased intangibles to capitalized as an asset
            1. Purchased patents, trademarks, customer lists, Goodwill
      2. Purchased Intangibles
         1. Purchased intangibles are usually added in an acquisition
            1. Intangible assets and liabilities must be separately recognized if:
            2. The intangible arises from a transferable contract or
            3. The intangible is separable
            4. Non-separable intangibles are included in Goodwill
         2. Intangibles with a definite life must be amortized over that life
            1. Patents, Copyrights, Customer Lists
         3. Intangibles with an indefinite life are not amortized
            1. Brand name, Goodwill
         4. All intangibles are subject to the usual asset impairment tests
      3. Intangibles: Goodwill
         1. When an acquirer purchases a target firm, the target's individual assets and liabilities are first adjusted to reflect their current market values
         2. Then, the acquirer records any separable or transferable intangible assets
         3. Finally, Goodwill equals the excess of the purchase price over the market value of net identifiable assets
      4. Goodwill Example
         1. Journal Entry Dr. Cash (+A) 2 Dr. Accts Rec (+A) 80 Dr. Inventory (+A) 78 Dr. Net PP&E (+A) 900 Dr. Customer List (+A) 200 Dr. Prop. Tech (+A) 500 Dr. Goodwill (+A) 440 Cr. Payables (+L) 170 Cr. Other Liabilities (+L) 30 Cr. Cash (-A) 2000
   3. Long-lived Assets Disclosure Example
      1. Lyons Inc. manufactures hurleys (the sticks used in the sport Hurling)
         1. In 2008, Lyons acquired Finch Corp., but the acquisition did not work out and Lyons took a Goodwill impairment charge in 2012
      2. We will use Lyons' footnote disclosures to answer the following questions
         1. PP&E
            1. What is the historical cost of Lyons' PP&E?
            2. How much new PP&E did the company acquire during 2012?
            3. What is the historical cost of the PP&E sold during 2012?
         2. Intangibles
            1. How many years does Lyons have left before its Patents expire?
            2. How did the Goodwill impairment affect Lyons financial statements and ratios in 2012?
      3. Lyons Inc.: Balance Sheet - Assets
      4. Lyons Inc.: Footnote 7: Property and equipment
      5. Lyons Inc.: SCF - Operating
      6. Lyons Inc.: SCF – Investing and Supplemental
         1. Dr. Cash (+A) 8.8 Dr. Acm. Depr. (-XA) 5.0 Dr. Loss on Sale (+E) 0.2 Cr. PP&E (-A) 14.0
      7. Balance the Acm Depr. Taccount
      8. Lyons Inc.: Footnote 8: Goodwill and other intangible assets
      9. What is the effect of Goodwill impairment?
         1. Dr. Loss (+E) 285.3 Cr. Goodwill (-A) 285.3
         2. Net Loss on Income Statement (will also negatively affect Retained Earnings)
         3. But, no impact on Cash from Operations (will not affect EBITDA either)
         4. Total Assets drop in 2012
         5. All ratios with Earnings, Assets, and Equity will be adversely affected!
   4. Marketable Securities
      1. Intercorporate Investments
         1. Investments in equity (stock) or debt (bonds) of another company
            1. Accounting treatment depends on influence and intent
         2. Small investment in equity (less than 20%) or investments in debt
            1. Marketable Securities (A)
            2. Three methods: Trading, Available-for-sale, and Held-to-Maturity (debt only)
         3. Strategic investment in equity (20% to 50% or "significant influence")
            1. Investment in Affiliates (A)
            2. Two methods: Equity method or Fair value accounting
         4. Control investment (greater than 50%)
            1. One method: Full consolidation
            2. Add all assets, liabilities, income of other company, recognize "noncontrolling interest"
      2. Marketable Securities: Equity
         1. Equity investments of less than 20% ownership in another firm are treated based on the "intent" in making investment
         2. Trading Securities
            1. Intent is to profit from short-term fluctuations in market prices (active management)
            2. Common in financial services firms and financial services divisions
         3. Available-for-Sale Securities (AFS)
            1. Intent is to earn returns over the medium-to-long term (invest excess cash until needed for a new project)
            2. Common in non-financial firms
         4. Trading vs. AFS
            1. Balance Sheet
            2. Both methods: Investment carried at fair value at the balance sheet date ("markto- market")
            3. Marking-to-market creates unrealized gains or losses
            4. Income Statement
            5. Trading: Unrealized gains/losses go on the Income Statement
            6. AFS: Unrealized gains/losses go into Accumulated Other Comprehensive Income
            7. AOCI is like a Retained Earnings account, except that transactions go directly into AOCI without appearing on the Income Statement
            8. AOCI "stores up" unrealized gains/losses until security is sold, when they are "reversed out" into the income statement
            9. Key disclaimer: Transactions go into AOCI net of taxes, but we are going to ignore taxes for this topic
         5. Example
            1. Purchase of investment
            2. Bott Bank buys $100 of TK stock (which is less than 20% ownership) – Decides to classify investment as a Trading security
            3. Journal entry: Dr. Marketable Securities (+A) 100 Cr. Cash (-A) 100
            4. Meyer Co. buys $100 of TK stock (which is less than 20% ownership) – Decides to classify investment as an AFS security
            5. Journal entry: Dr. Marketable Securities (+A) 100 Cr. Cash (-A) 100
            6. No difference in the two methods!
            7. Receive a dividend
            8. Bott Bank receives $5 of dividends from TK stock
            9. Journal entry: Dr. Cash (+A) 5 Cr. Dividend Revenue (+R) 5
            10. Meyer Co. receives $5 of dividends from TK stock
            11. Journal entry: Dr. Cash (+A) 5 Cr. Dividend Revenue (+R) 5
            12. No difference in the two methods!
            13. Mark-to-market on balance sheet date
            14. At quarter end, Bott Bank's investment in TK stock is now worth $103
            15. Journal entry: Dr. Marketable Securities (+A) 3 Cr. Gain on investments (+R, +SE) 3
            16. At quarter end, Meyer Co.'s investment in TK stock is now worth $103
            17. Journal entry: Dr. Marketable Securities (+A) 3 Cr. AOCI (+SE) 3
            18. Unrealized gain is part of Net Income for Trading (Bott) and bypasses Net Income for AFS (Meyer)
            19. Sale of investment
            20. After quarter end, Bott Bank sells its TK stock for $101
            21. Journal entry: Dr. Cash (+A) 101 Dr. Loss on investment (+E, -SE) 2 Cr. Marketable Securities (-A) 103
            22. After quarter end, Meyer Co. sells its TK stock for $101
            23. Journal entry: Dr. Cash (+A) 101 Dr. AOCI (-SE) 3 Cr. Gain on investment (+R, +SE) 1 Cr. Marketable Securities (-A) 103
            24. Realized gain/loss based on last balance sheet value (103) for Trading (Bott) and based on original cost (100) for AFS (Meyer)
         6. Alternate Reality
            1. Mark-to-market on balance sheet date
            2. At quarter end, Bott Bank's investment in TK stock is now worth $97
            3. Journal entry: Dr. Loss on investment (+E, -SE) 3 Cr. Marketable Securities (-A) 3
            4. At quarter end, Meyer Co.'s investment in TK stock is now worth $97
            5. Journal entry: Dr. AOCI (-SE) 3 Cr. Marketable Securities (-A) 3
            6. Unrealized loss is part of Net Income for Trading (Bott) and bypasses Net Income for AFS (Meyer)
            7. Sale of investment
            8. After quarter end, Bott Bank sells its TK stock for $101
            9. Journal entry: Dr. Cash (+A) 101 Cr. Gain on investment (+R, +SE) 4 Cr. Marketable Securities (-A) 97
            10. After quarter end, Meyer Co. sells its TK stock for $101
            11. Journal entry: Dr. Cash (+A) 101 Cr. AOCI (+SE) 3 Cr. Gain on investment (+R, +SE) 1 Cr. Marketable Securities (-A) 97
            12. Realized gain is based on last balance sheet value (97) for Trading (Bott) and based on original cost (100) for AFS (Meyer)
         7. Summary
      3. Marketable Securities: Debt
         1. Debt investments are can be accounted for as trading, available-forsale (AFS), or "held-to-maturity" securities.
         2. Held-to-Maturity Securities (HTM)
            1. Firm has both the ability and intent to hold the debt investment until it matures.
            2. Do not mark-to-market
            3. Recognize interest revenue each period
      4. SCF Effects of Marketable Securities
         1. Trading Securities
            1. Operating activities
            2. Add decreases (or subtract increases) in balance sheet account in Cash Flow from Operations section
            3. (i.e. treat just like Accounts Receivable and Inventory)
         2. Available-for-sale and Held-to-maturity securities
            1. Investing activities
            2. Cash for purchases and from sales is listed in the Cash Flow from Investing Activities section
            3. Add back realized losses (or subtract realized gains) in Cash Flow from Operations section
            4. (i.e. treat just like Property, Plant, and Equipment)
      5. Marketable Securities Disclosure Example
         1. BOC Automotive (BOCA) has a financial services segment that helps its customers finance the purchase of cars
            1. As part of its business, this segment invests in marketable securities
            2. We will use BOCA's footnote disclosures to answer the following questions
            3. What is the cost, fair value, and book value (i.e., balance sheet value) of BOCA's marketable securities as of 12/31/2012?
            4. What are the accumulated unrealized gains and losses as of 12/31/2012? Where have they been recognized?
            5. Did BOCA recognize gains or losses from selling securities during 2012? What was the book value of securities sold by BOCA during 2012?
            6. Could BOCA have increased its pre-tax income in 2012 through changes in how it managed its marketable securities?
         2. BOCA: Footnote 6: Marketable Securities
            1. Journal Entry: Dr. Cash (+A) 9,100 Dr. Loss on sale (+E) 32 Dr. AOCI (-SE) 18 Cr. Marketable Securities (-A) 9,150
            2. What was book value of securities sold? – $9,150
         3. Any ways to increase 2012 pretax income?
            1. AFS: Sell securities with unrealized gains +$39
            2. AFS: Don't sell securities with unrealized losses + $56
            3. Reclassify…
            4. TS losses to AFS
            5. AFS gains to TS
            6. HTM gains to TS
8. Liabilities and Long-term Debt
   1. Time Value of Money
      1. Time Value of Money
         1. The value of a dollar today is not the same as the value of a dollar in the past or in the future
         2. The time value of money differs because of inflation, interest, risk
            1. These factors combine to determine the "discount rate" or "rate of return"
         3. Whenever we will receive or pay cash in the future, we must adjust the cash flows to the same value (usually, today's value)
            1. Much like you have to adjust foreign currencies to the US dollar (or liters to gallons) to make cross-country comparisons, you have to adjust future dollars or past dollars to today's value to make across-time comparisons
      2. Gasoline Prices
         1. Who paid the highest price for gas?
            1. May 2011, Fort Worth, Texas: $4.15 per gallon
            2. May 2011, Saskatoon, Saskatchewan, C$1.04 per liter
            3. May 1980, Fort Worth, Texas: $1.53 per gallon
         2. May 2011, Saskatoon
            1. Convert liters to gallons => 1 gallon = 3.79 liter
            2. C$1.04/liter * 3.79 = C$3.94 / gallon
            3. Convert C$ to US$ => C$1 = $1.05
            4. C$3.94 * 1.05 = $4.14 per gallon
         3. May 1980, Fort Worth
            1. Convert 1980 $ to 2011 $ => $1 in 1980 = $2.72 in 2011
            2. $1.53 * 2.72 = $4.16 per gallon in 2011 $
      3. Compound Interest
         1. Invest $100 in a Certificate of Deposit that earns 8% interest per year
         2. At the end of the first year, you have:
            1. $100 + $8 interest = $108
            2. This is the same as: $100 x (1 + 0.08) = $108
         3. At the end of the second year, you have:
            1. $108 x (1.08) = $116.64
            2. Note that you don’t have: $100 + ($8 x 2) = $116
            3. But you do have: $100 x (1.08) x (1.08) = $116.64
            4. Which is the same as: $100 x (1.08)^2 = $116.64
         4. At the end of the third year, you have:
            1. $116.64 x (1.08) = $125.97 or
            2. $100 x (1.08)^3 = $125.97
      4. Generalizing the Idea
         1. At the end of the nth year, you have:
            1. Future Value in n years (FV) = $100 x (1.08)^n
         2. If the CD paid r% interest instead of 8% interest:
            1. FV = $100 x (1 + r)^n
         3. If your initial investment was $PV instead of $100
            1. FV = PV x (1 + r)^n
         4. Thus, the Present Value (PV) of what you invest today at an interest rate r grows by (1 + r)n to earn a Future Value (FV) in n years from now
      5. Time Value of Money Calculations
         1. Elements
            1. PV = Present value (value before effects of interest or discounting)
            2. FV = Future value (value after effects of interest or discounting)
            3. r = Interest rate, discount rate, or rate of return
            4. n = Number of periods between present value and future value
         2. Future Value (FV) Calculations
            1. FV = PV x (1 + r)^n or
            2. FV = PV x (Table 1 factor for n, r) or =-FV(r,n,0,PV) in Excel (r of 10% would be 0.10)
            3. If you invested $10,000 in the stock market today, how much money would you have at retirement?
            4. Assume the following:
            5. 20 years to retirement
            6. Expected rate of return in stock market is 15% (compounded annually)
            7. Examples
            8. If you invested $10,000 in the stock market today, how much money would you have at retirement?
            9. Assume the following:
            10. 20 years to retirement (n)
            11. Expected rate of return (r) in stock market is 15% (compounded annually)
            12. FV = PV x (1 + r)^n
            13. FV = 10,000 x (1.15)20 = $163,665
            14. Or FV = 10,000 X (Table 1 factor for 20, 15%)
            15. FV = 10,000 x 16.3665
            16. FV = $163,665
            17. What if the expected return is only 5%?
            18. Assume the following:
            19. 20 years to retirement (n)
            20. Expected rate of return (r) is 5% (compounded annually)
            21. FV = 10,000 x (1.05)^20 or
            22. FV = 10,000 X (Table 1 factor for 20, 5%)
            23. FV = 10,000 x 2.6533
            24. FV = $26,533
            25. What if you plan to retire in 10 years?
            26. Assume the following:
            27. 10 years to retirement (n)
            28. Expected rate of return (r) is 15% (compounded annually)
            29. FV = 10,000 x (1.15)^10 or
            30. FV = 10,000 X (Table 1 factor for 10, 15%)
            31. FV = 10,000 x 4.0456
            32. FV = $40,456
            33. How about 30 years? How about 25%? …
            34. What do you notice?
            35. Future value (FV) is positively related to the rate of return (r) and the number of periods (n)
         3. Present Value
            1. What if we know the Future Value, but don't know the Present Value?
            2. FV = PV x (1 + r)^n => PV = FV / (1 + r)^n
            3. How much would you have to invest today in a CD that earns 8% interest/year to have $108 next year?
            4. PV = $108 / (1.08) = $100
            5. How about if you want $125.97 in three years?
            6. PV = $125.97 / (1.08)^3 = $100
            7. How about if you want $100 next year?
            8. PV = $100 / (1.08) = $92.59
            9. The present value of $1 next year is 93 cents at 8%
         4. Present Value (PV) Calculations
            1. PV = FV / (1 + r)n or
            2. PV = FV x (Table 2 factor for n, r) or =-PV(r,n,0,FV) in Excel (r of 10% would be 0.10)
            3. Examples
            4. How much should you have invested in a savings bond twenty years ago to have $10,000 today?
            5. Assume the following:
            6. Savings bonds have no periodic interest payments (interest is added to the principal and compounded)
            7. Interest on the bond was 15% (compounded annually)
            8. PV = 10,000 / (1.15)^20 or
            9. PV = 10,000 X (Table 2 factor for 20, 15%)
            10. PV = 10,000 x 0.0611
            11. PV = $611
            12. What if the interest rate was only 5%?
            13. Assume the following:
            14. Savings bonds have no periodic interest payments (interest is added to the principal and compounded)
            15. Interest on the bond (r) was 5% (compounded annually)
            16. PV = 10,000 / (1.05)^20 or
            17. PV = 10,000 X (Table 2 factor for 20, 5%)
            18. PV = 10,000 X 0.3769
            19. PV = $3,769
            20. What if you bought the savings bond ten years ago?
            21. Assume the following:
            22. Savings bonds have no periodic interest payments (interest is added to the principal and compounded)
            23. Interest on the bond (r) was 15% (compounded annually)
            24. PV = 10,000 / (1.15)^10 or
            25. PV = 10,000 X (Table 2 factor for 10, 15%)
            26. PV = 10,000 x 0.2472
            27. PV = $2,472
            28. How about 30 years? How about 25%? …
            29. What do you notice?
            30. Present value (PV) is inversely related to the rate of return (r) and the number of periods (n)
         5. Net Present Value and Decision Making
            1. Lay out a timeline of the cash inflows and outflows
            2. Convert the cash flows in each period to the present values
            3. Add up the present values
            4. Net Present Value is the sum of the present values
            5. Often involves a cash outflow in today's dollars and cash inflows in future dollars, which must discounted back to present value.
      6. Annuities
         1. An Annuity is a constant stream of future cash flows
            1. Ordinary Annuity (annuity in arrears):
            2. Payments are at the end of a period
            3. Annuity Due (or in advance):
            4. Payments are at the start of a period
            5. Example: PV of an Ordinary Annuity of $500 for three periods at an interest rate of 8%
            6. PV of $500 one year from now at 8% = 500 x .92593 + PV of $500 two years from now at 8% = 500 x .85734 + PV of $500 three years from now at 8% = 500 x .79383 = $500 x 2.57710 = $1,288.55
         2. Present Value of Annuities Calculations
            1. PV = PMT/r x [1 - 1/(1 + r)n] or
            2. PV = PMT x (Table 4 factor for n, r) or =-PV(r,n,PMT,0) in Excel (r of 10% would be 0.10)
            3. Examples
            4. If this course gets you an extra $5,000 per year in salary until retirement, how much would you be willing to pay for it?
            5. Assume the following:
            6. 20 years to retirement
            7. Inflation is expected to be 15% (compounded annually)
            8. PV = 5,000 X (Table 4 factor for 20, 15%)
            9. PV = 5,000 x 6.2593
            10. PV = $31,297
            11. What if the inflation rate was only 5%?
            12. Assume the following:
            13. Extra salary per year (PMT) is $5,000
            14. 20 years to retirement (n)
            15. Inflation (r) is expected to be 5% (compounded annually)
            16. PV = 5,000 x (Table 4 factor for 20, 5%)
            17. PV = 5,000 x 12.4622
            18. PV = $62,311
            19. What if you plan to retire in 10 years?
            20. Assume the following:
            21. Extra salary per year (PMT) is $5,000
            22. 10 years to retirement (n)
            23. Inflation (r) is 15% (compounded annually)
            24. PV = 5,000 x (Table 4 factor for 10, 15%)
            25. PV = 5,000 x 5.0188
            26. PV = $25,094
            27. How about 30 years? How about 25%? How about $10,000 extra salary…
            28. What do you notice?
            29. Present value (PV) is inversely related to r
            30. PV is positively related to PMT and n
         3. Future Value of Annuities Calculations
            1. FV = PMT x (Table 3 factor for n, r) or =-FV(r,n,PMT,0) in Excel (r of 10% would be 0.10)
            2. Example:
            3. If this course gets you an extra $5,000 per year in salary until retirement, how much is this worth when you retire?
            4. Assume the following:
            5. 20 years to retirement
            6. Inflation is expected to be 15% (compounded annually)
            7. FV = 5,000 X (Table 3 factor for 20, 15%)
            8. FV = 5,000 x 102.4436
            9. FV = $512,218
            10. Recall that investing $10,000 in the stock market with 15% r for 20 years:
            11. FV = 10,000 x 16.3665 = $163,635
         4. Different Compounding Periods
            1. What about semi-annual compounding? (Bonds)
            2. Divide the annual rate (r) by 2 and multiply years (n) by 2
            3. What is PV of $1,000, 5-year, 12% savings bond with…
            4. Annual compounding?
            5. PV = 1,000 X (Table 2 factor for 5, 12%) = $567
            6. Semi-annual compounding?
            7. PV = 1,000 X (Table 2 factor for 10, 6%) = $558
            8. Monthly compounding?
            9. PV = 1,000 X (Table 2 factor for 60, 1%) = $550
            10. Daily compounding?
            11. PV = 1,000 X (Table 2 factor for 1825, 0.033%) = $549
            12. Example: Price of a Bond
            13. How much would you pay to buy a newly issued 3-year bond that pays coupon payments of $250 every six months and $10,000 at maturity. The current market interest rate is 5.0%.
            14. PV calculation to get bond price:
            15. With semi-annual payments, double the number of periods (3 x 2 = 6) and divide the interest rate by 2 (5% / 2 = 2.5%)
            16. Present value of payment at maturity
            17. PV = ?, FV = 10,000, r = 0.025, n = 6, PMT = 0 (use Excel, calculator, or PV table to solve)
            18. PV = $8,623
            19. Present value of semi-annual payment
            20. PV = ?, FV = 0, r = 0.025, n = 6, PMT = 250
            21. PV = $1,377
            22. Price = $10,000 (8,623 + 1,377)
   2. Long-Term Debt and Bonds
      1. Long-term Liabilities
         1. Current Liabilities (due within less than one year)
            1. Initially booked at nominal value (not present value)
         2. Long-term Liabilities (due in periods beyond one year)
            1. Initially booked at present value of future cash payments
         3. After initial recognition, some liabilities can be marked to fair value, while most are recorded at amortized cost
            1. As a result, liabilities can be a mix of fair value and amortized cost
      2. Common Types of Debt
         1. Bank loan
            1. Borrow principal; make periodic interest payments; repay principal at end of loan
         2. Mortgage
            1. Borrow principal; make periodic interest and principal payments over the loan period
         3. Corporate bonds
            1. Company promises to pay periodic cash flows ("coupons"), plus a lump sum ("principal") at maturity.
            2. Investors offer the company the present value of coupons and principal
            3. Investors can then trade the bonds freely until maturity.
            4. "Zero-coupon": company only pays lump sum at maturity
         4. Accounting for a Bank Loan
            1. On 1/1/2010, KP Inc. borrows $10,000 from a bank for a 3-year loan. The bank charges the firm 5.0% interest per year on the loan.
            2. Issuance 1/1/10 Dr. Cash (+A) 10,000 Cr. Notes Payable (+L) 10,000
            3. Periodic interest payments 12/31/10 Dr. Interest Expense (+E) 500 Cr. Cash (-A) 500 12/31/11 Dr. Interest Expense (+E) 500 Cr. Cash (-A) 500
            4. Repayment 12/31/12 Dr. Notes Payable (-L) 10,000 Dr. Interest Expense (+E) 500 Cr. Cash (-A) 10,500
         5. Accounting for a Mortgage
            1. On 1/1/2010, KP Inc. borrows $10,000 from a bank on a 3-year mortgage. The bank charges KP 5.0% interest/year on the mortgage. The required payment is $3,672 per year.
            2. PV calculation to get payment:
            3. PV = 10,000, FV = 0, r = 0.05, n = 3, PMT = ? (use Excel/calculator/PV table to solve)
            4. PMT = $3,672
            5. Issuance 1/1/10 Dr. Cash (+A) 10,000 Cr. Mortgage Payable (+L) 10,000
            6. 2010 payment 12/31/10 Dr. Mortgage Payable (-L) 3,172 Dr. Interest Expense (+E) 500 Cr. Cash (-A) 3,672
            7. 2011 payment 12/31/11 Dr. Mortgage Payable (-L) 3,331 Dr. Interest Expense (+E) 341 Cr. Cash (-A) 3,672
            8. 2012 payment 12/31/12 Dr. Mortgage Payable (-L) 3,497 Dr. Interest Expense (+E) 175 Cr. Cash (-A) 3,672
      3. Bonds Payable
         1. Coupon bonds require semi-annual coupon payments plus payment of face value at maturity
         2. Elements and Terminology
            1. Price or proceeds (PV)
            2. Face value or par value (FV)
            3. Market interest rate or effective rate or yield-to-maturity (r)
            4. Coupon rate (stated in bond agreement)
            5. Coupon payment (PMT) = face value * coupon rate
            6. Number of periods (n)
            7. Because bonds are semi-annual, double the number of periods and divide rates by 2
         3. Bond Price
            1. Price = Present value of FV + Present Value of PMT
            2. Accounting for a Bond
            3. On 1/1/2010, KP Inc. issues a 3-year, 5% coupon, $10,000 face value bond. Investors price the bond using an effective (market) interest rate of 5.0%. KP receives proceeds from the bond of $10,000.
            4. PV calculation to get bond price:
            5. Double the number of periods and divide the interest rate by 2!
            6. Present value of face value
            7. PV = ?, FV = 10,000, r = 0.025, n = 6, PMT = 0 (use Excel, calculator, or PV table to solve)
            8. PV = $8,623
            9. Present value of payment
            10. PV = ?, FV = 0, r = 0.025, n = 6, PMT = 250 (10,000 x 0.025)
            11. PV = $1,377
            12. Price = $10,000 (8,623 + 1,377)
            13. Can also get price by putting in all elements
            14. PV = ?, FV = 10,000, r = 0.025, n=6, PMT = 250
            15. PV = $10,000
            16. Issuance 1/1/10 Dr. Cash (+A) 10,000 Cr. Bonds Payable (+L) 10,000
            17. Periodic coupon payments Dr. Interest Expense (+E) 250 Cr. Cash (-A) 250
            18. Payment at maturity 12/31/12 Dr. Bonds Payable (-L) 10,000 Dr. Interest Expense (+E) 250 Cr. Cash (-A) 10,250
      4. Discount and Premium Bonds
         1. The KP bond was assumed to be "issued at par" with coupon rate = effective (market) rate
         2. But, companies can issue bonds with coupon payments of any amount, regardless of the market rate.
         3. When the coupon rate is below the market rate, the bond is referred to as a "discount bond."
            1. Price is below face value; investors pay less for bond because coupon rate is less than current market rate
         4. When the coupon rate is above the market rate, the bond is referred to as a "premium bond."
            1. Price is above face value; investors pay more for bond because coupon rate is greater than current market rate
         5. Effective Interest Method
            1. Interest Expense only equals the coupon payment for bonds issued at par
            2. Interest expense must be based on the "effective interest rate"
            3. Effective interest rate is the market rate in effect at the time of issuance
            4. The effective rate is not changed over the life of the bond, even when market interest rates change
            5. Interest Expense journal entry Dr. Interest Expense (+E) <Bonds Pay Bal x Effective Int Rate> Dr. or Cr. Bonds Payable <Plug> Cr. Cash (-A) <Face Value x Coupon Rate>
            6. If Interest Expense does not equal Cash, there will be a Dr or Cr to Bonds Payable to balance the entry
         6. Bond issued at par
            1. Effective rate = 5%; Coupon rate = 5%; Proceeds = $10,000; Face Value = $10,000
            2. Dr. Interest Expense (+E) 250 (10,000 x 0.025) <Bonds Pay Bal x Effective Int Rate> Cr. Cash (-A) 250 (10,000 x 0.025) <Face Value x Coupon Rate>
         7. Bond issued at a discount
            1. Effective rate = 6%; Coupon rate = 5%; Proceeds = $9,729; Face Value = $10,000
            2. Dr. Interest Expense (+E) 292 (9,729 x 0.03) Cr. Bonds Payable (+L) 42 (plug) Cr. Cash (-A) 250 (10,000 x 0.025)
         8. Bond issued at a premium
            1. Effective rate = 4%; Coupon rate = 5%; Proceeds = $10,280; Face Value = $10,000
            2. Dr. Interest Expense (+E) 206 (10,280 x 0.02) Dr. Bonds Payable (-L) 44 (plug) Cr. Cash (-A) 250 (10,000 x 0.025)
         9. Accounting for a Discount Bond
            1. On 1/1/2010, KP Inc. issues a 3-year, 5% coupon, $10,000 face value bond. Investors price the bond using an effective (market) interest rate of 6.0%. KP receives proceeds from the bond of $9,729.
            2. PV calculation to get bond price:
            3. PV = ?, FV = 10,000, r = 0.03, n=6, PMT = 250 (10,000 x 0.025) Note the r = effective rate and PMT based on coupon rate
            4. PV = $9,729
            5. Issuance 1/1/10 Dr. Cash (+A) 9,729 Cr. Bonds Payable (+L) 9,729
            6. 6/30/10 Dr. Interest Expense (+E) 292 (9729 x 0.03) Cr. Bonds Payable (+L) 42 (plug) Cr. Cash (-A) 250 (10,000 x 0.025)
            7. 12/31/12 Dr. Interest Expense (+E) 299 Dr. Bonds Payable (-L) 10,000 Cr. Bonds Payable (+L) 49 Cr. Cash (-A) 10,250
         10. Accounting for a Discount Bond and the SCF
             1. For bonds issued at a discount, part of the Interest Expense will be noncash each period
             2. The noncash amount is equal to the plug to Bonds Payable
             3. 6/30/10 Dr. Interest Expense (+E) 292 (9729 x 0.03) Cr. Bonds Payable (+L) 42 (noncash interest) Cr. Cash (-A) 250 (10,000 x 0.025)
             4. The noncash amount must be added back in the Operating section of the SCF under the indirect method
             5. This line item is often called "Amortization of Bond Discount"
         11. Accounting for a Premium Bond
             1. On 1/1/2010, KP Inc. issues a 3-year, 5% coupon, $10,000 face value bond. Investors price the bond using an effective (market) interest rate of 4.0%. KP receives proceeds from the bond of $10,280.
             2. PV calculation to get bond price:
             3. PV = ?, FV = 10,000, r = 0.02, PMT = 250 (10,000 x 0.025), n = 6 Note the r = effective rate and PMT based on coupon rate
             4. PV = $10,280
             5. Issuance 1/1/10 Dr. Cash (+A) 10,280 Cr. Bonds Payable (+L) 10,280
             6. 6/30/10 Dr. Interest Expense (+E) 206 (10,280 x 0.02) Dr. Bonds Payable (-L) 44 (plug) Cr. Cash (-A) 250 (10,000 x 0.025)
             7. 12/31/12 Dr. Interest Expense (+E) 201 Dr. Bonds Payable (-L) 10,049 (10,000 + 49) Cr. Cash (-A) 10,250
      5. Retirement Before Maturity
         1. Firms sometimes "retire" bonds prior to maturity if they have excess cash or as part of refinancing activities
         2. The firm typically must buy the bonds back from investors at current market prices.
         3. The price the firm pays to buy back the bonds will typically be different from the book value of the bonds.
         4. A gain or loss is recorded on income statement for the difference between the book value and the price of the bonds
            1. This gain or loss is backed out of the Operating section of the SCF under the indirect method because it is a financing activity
         5. Loss
            1. On 7/1/2011, KP Inc. decides to buy back its a 3-year, 5% coupon, $10,000 face value bond, which was issued at an effective interest rate of 6%. The market interest rate has dropped to 4%, so KP must pay $10,144 to retire the bond.
            2. 7/1/11 Dr. Bonds Payable (-L) 9,858 Dr. Loss on retirement (+E) 286 Cr. Cash (-A) 10,144
         6. Gain
            1. On 7/1/2011, KP Inc. decides to buy back its a 3-year, 5% coupon, $10,000 face value bond, which was issued at an effective interest rate of 6%. The market interest rate has climbed to 8%, so KP must pay $9,584 to retire the bond.
            2. 7/1/11 Dr. Bonds Payable (-L) 9,858 Cr. Gain on retirement (+R) 274 Cr. Cash (-A) 9,584
      6. Fair Value Option
         1. Under both US GAAP and IFRS, companies have the option to measure long-term debt at fair (market) value rather than at amortized cost using historical market interest rates.
            1. Under amortized cost, the book value of long-term debt on the balance sheet can deviate substantially from the current fair market value of the debt.
         2. Under the fair value option, companies must adjust book value of long-term debt each period to reflect the current market value.
         3. Increase in market value: Dr. Unrealized loss (+E) xxx Cr. Bonds Payable (+L) xxx
         4. Decrease in market value: Dr. Bonds Payable (-L) xxx Cr. Unrealized gain (+R) xxx
   3. Leases
      1. A lease is a rental agreement
         1. One party (the lessor) transfers to another party (the lessee) the right to use an asset for a stated period of time in return for a stated series of payments
      2. Commonly leased assets
         1. Airplanes, buildings, equipment, vehicles
      3. Leases can be of any duration
         1. Short-term leases: Allow use of an asset that would be inefficient to purchase
            1. Use of rental car for one week under a contract that can be cancelled at any time
         2. Long-term leases: Similar to a financing arrangement to purchase a long-lived asset
            1. Use of a car for 5 years under a noncancellable contract
      4. Capital Lease vs. Operating Lease
         1. Accounting rules require that certain long-term leases be treated as if the company bought the asset with debt financing
         2. Capital leases
            1. Record a Lease Asset and Lease Liability on the Balance Sheet
            2. Record Depreciation Expense and Interest Expense on the Income Statement
            3. Firms must use capital lease accounting if one of the following applies:
            4. Ownership is transferred at end of lease
            5. Lease period covers more than 75% of asset's life
            6. A "bargain purchase" option exists (right to buy asset at lease end for less than market value)
            7. Present value of contractual future lease payments is at least 90% of the current market value of the asset
            8. Tax rules are different and are irrelevant for the choice of capital vs. operating lease accounting for financial reporting
         3. But, other long-term leases can still be treated as rentals
         4. Operating leases
            1. "Off-balance sheet" activity: No asset or liability on the balance sheet
            2. Record Rent Expense on the Income Statement
         5. Example
            1. Operating Lease
            2. On January 1, 2010, Ople Inc. signs a 3-year lease on a supercomputer, which is delivered that day. The lease requires payments of $19,709 at the end of each year.
            3. There is no bargain purchase option or ownership transfer at the end of the lease.
            4. Ople's managers estimate that the lease term is 60% of the asset's life.
            5. Ople’s managers compute the present value of the lease payments as $44,264 using a 16% rate. This PV is 88.5% of the current market value of $50,000. PV = ?, n = 3, r = 0.16, PMT = 19,709 => Excel: =-PV(0.16,3,19709) = 44,264
            6. Journal entry: 1/1/10 No entry
            7. On December 31, 2010, Ople makes its lease payment of $19,709.
            8. Journal entry: 12/31/10 Dr. Rent Expense (+E) 19,709 Cr. Cash (-A) 19,709
            9. On December 31, 2011, Ople makes its lease payment of $19,709.
            10. Journal entry: 12/31/11 Dr. Rent Expense (+E) 19,709 Cr. Cash (-A) 19,709
            11. On December 31, 2012, Ople makes its lease payment of $19,709.
            12. Journal entry: 12/31/12 Dr. Rent Expense (+E) 19,709 Cr. Cash (-A) 19,709
            13. Summary for Operating Lease
            14. Capital Lease
            15. On January 1, 2010, Caple Inc. signs a 3-year lease on a supercomputer, which is delivered that day. The lease requires payments of $19,709 at the end of each year.
            16. There is no bargain purchase option or ownership transfer at the end of the lease.
            17. Caple's managers estimate that the lease term is 60% of the asset's life.
            18. Caple's managers compute the present value of the lease payments as $45,000 using a 15% rate. This PV is 90% of the current market value of $50,000. PV = ?, n = 3, r = 0.15, PMT = 19,709 => Excel: =PV(0.15,3,19709) = 45,000
            19. Journal entry: 1/1/10 Dr. Lease Asset (+A) 45,000 Cr. Lease Liability (+L) 45,000
            20. Under capital lease treatment, Caple will do the following subsequent accounting
            21. Lease Asset is depreciated on a straight-line basis for three years with no salvage value
            22. Treated just like an Long-Lived Asset
            23. Lease Liability is accounted for using the effective interest method, with part of the lease payment considered Interest Expense and part considered payment of principal (i.e., reduction in Lease Liability)
            24. The interest expense will be equal to the beginning balance in Lease Liability times 15% (the effective interest rate)
            25. Treated just like a Mortgage Payable
            26. On December 31, 2010, Caple makes its lease payment of $19,709. Caple also must recognize depreciation on the supercomputer.
            27. Journal entries: 12/31/10 Dr. Interest Expense (+E) 6,750 (45,000 x 0.15) Dr. Lease Liability (-L) 12,959 (19,709 – 6,750) Cr. Cash (-A) 19,709 12/31/10 Dr. Depreciation Exp (+E) 15,000 (45,000 / 3) Cr. Acm Depreciation (+XA) 15,000
            28. The total expense is $21,750 (6,750 + 15,000)
            29. The ending balance of Lease Liability is $32,041 (45,000 – 12,959)
            30. On December 31, 2011, Caple makes its lease payment of $19,709. Caple also must recognize depreciation on the supercomputer.
            31. Journal entries: 12/31/11 Dr. Interest Expense (+E) 4,806 (32,041 x 0.15) Dr. Lease Liability (-L) 14,903 (19,709 – 4,806) Cr. Cash (-A) 19,709 12/31/11 Dr. Depreciation Exp (+E) 15,000 (45,000 / 3) Cr. Acm Depreciation (+XA) 15,000
            32. The total expense is $19,806 (4,806 + 15,000)
            33. The ending balance of Lease Liability is $17,138 (32,041 – 14,903)
            34. On December 31, 2012, Caple makes its lease payment of $19,709. Caple also must recognize depreciation on the supercomputer.
            35. Journal entries: 12/31/12 Dr. Interest Expense (+E) 2,571 (17,138 x 0.15) Dr. Lease Liability (-L) 17,138 (19,709 – 2,571) Cr. Cash (-A) 19,709 12/31/12 Dr. Depreciation Exp (+E) 15,000 (45,000 / 3) Cr. Acm Depreciation (+XA) 15,000
            36. The total expense is $17,571 (2,571 + 15,000)
            37. The ending balance of Lease Liability is $0 (17,138 – 17,138)
            38. Summary for Capital Lease
            39. Capital vs. Operating Lease
            40. Capital leases have higher expenses in early years, lower expenses in later years
            41. Total expense over lease term is the same
            42. Capital leases have higher Assets and Liabilities than Operating leases, which are "off-balance sheet"
            43. SCF and Capital vs. Operating Lease
            44. Capital leases always have higher Cash From Operations
            45. Operating leases
            46. Rent Expense is an Operating Cash Flow
            47. Capital leases
            48. Interest Expense is an Operating Cash Flow
            49. Reduction in the Lease Liabilities in a Financing Cash Flow
            50. Depreciation Expense is a non-cash expense
      5. Lease Accounting Controversy
         1. This accounting for leases is controversial because operating lease accounting allows firms to keep substantial financial obligations off their balance sheet, potentially distorting the firm's leverage
         2. The FASB and IASB are both currently considering proposals to eliminate operating lease accounting
      6. Converting Operating Leases to Capital Leases
         1. Adjust Balance Sheet
            1. Calculate the PV of minimum future operating lease payments disclosed in footnotes
            2. Capitalize these leases by adding the PV to Long-term Assets and to Long-term Debt Or, as a quick shortcut, multiply Rent Expense by 8 to estimate the asset/liability
         2. Adjust Income Statement
            1. Determine amortization expense and interest expense on newly capitalized leases and deduct from net income
            2. Add back rent expense on operating lease to net income
         3. Adjust Statement of Cash Flows
            1. Determine the principal portion of the lease payment (i.e. lease payment – interest expense)
            2. Add the principal portion to CFO (so only interest portion is still included) and subtract principal portion from CFF (Statement of cash flows done)
         4. Now, recompute all of your favorite ratios so you can compare firms without their ratios being distorted by different accounting treatments of leases
9. Deferred Taxes
   1. Income Taxes: Overview and Terminology
      1. Tax Reporting vs. Financial Reporting
      2. Example
         1. EBITDA in this example is Earnings before depreciation, municipal bond interest revenue, and taxes
         2. Permanent Differences
            1. Revenues that are never included in taxable income and expenses that are never deductible for tax purposes
            2. Examples: Interest on tax-exempt municipal bonds, tax penalties and tax credits, state and foreign taxes
            3. Do not reverse over time
            4. Cause the Effective Tax Rate to not equal the Statutory Tax Rate
         3. Temporary Differences
            1. Revenues or expenses recognized in a different period for tax purposes than for financial reporting purposes
            2. Examples: book vs. tax depreciation, bad debt expense, unearned revenue
            3. Reverse over time
            4. Stored up in Deferred Tax Assets and Liabilities
         4. Pre-tax Income vs. Taxable Income
            1. Pre-Tax Income: Earnings before taxes under GAAP
            2. Taxable Income: Earnings before taxes under tax rules
            3. Differences between pre-tax income and taxable income arise from permanent and temporary differences
         5. Income Tax Payable
            1. Statutory rate: Tax rate set by the government
            2. Income Tax Payable: Taxes owed to the government
            3. Taxable income x statutory rate
         6. Adjusted Pre-Tax Income
            1. Used to compute Income Tax Expense for financial reporting purposes
            2. Pre-tax income adjusted for permanent tax differences
         7. Income Tax Expense
            1. Number reported on the income statement
            2. Adjusted Pre-Tax Income x Statutory rate
            3. Differs from Income Tax Payable due to Temporary Differences
         8. Income Tax Expense vs. Income Tax Payable
            1. Temporary Differences reverse over time!
         9. Effective Tax Rate
            1. Effective Tax Rate = Income Tax Expense / Pre-Tax Income
            2. Does not equal 35% (Statutory Rate) because of Permanent Differences
            3. Does not reverse
         10. Tax Expense Calculation: Summary
   2. Deferred Tax Liabilities
      1. Temporary Differences
         1. Differences between Income Tax Expense on the financial statements and Income Tax Payable to the government that will reverse over time
         2. Income Tax Expense = Adjusted Pre-tax income x statutory tax rate
            1. Adjusted Pre-tax income based on GAAP rules and excludes permanent differences
            2. For convenience, I will say Pre-Tax Income instead of Adjusted Pre-Tax Income
            3. Expense on income statement
         3. Income Tax Payable = Taxable income x statutory tax rate
            1. Taxable income based on tax code rules
            2. Paid to the government
         4. Temporary Differences are stored in Deferred Tax Assets and Liabilities
         5. We will use 35% as the statutory tax rate in all calculations unless otherwise noted
      2. Deferred Tax Liabilities
         1. Arise from temporary differences where, initially, tax rules require bigger expenses or smaller revenues than GAAP
            1. Pre-tax income > Taxable income
            2. Income tax expense > Income tax payable
         2. In the future, GAAP will require bigger expenses or smaller revenues than tax rules
            1. Pre-tax income < Taxable income
            2. Income tax expense < Income tax payable
         3. The Deferred Tax Liability represents the obligation to make higher tax payments in the future
      3. Example
         1. Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it estimates that the machine will have a 3-year life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years.
         2. 2010 Journal entry Dr. Income Tax Expense (+E) 21,000 Cr. Deferred Tax Liability (+L) 14,000 Cr. Income Tax Payable (+L) 7,000
         3. 2011 Journal entry Dr. Income Tax Expense (+E) 21,000 Dr. Deferred Tax Liability (-L) 4,550 Cr. Income Tax Payable (+L) 25,550
         4. 2012 Journal entry Dr. Income Tax Expense (+E) 21,000 Dr. Deferred Tax Liability (-L) 9,450 Cr. Income Tax Payable (+L) 30,450
         5. Temporary difference
         6. Timing of depreciation expense and tax expense is shifted across time
         7. But totals are the same between books and taxes
   3. Deferred Tax Assets and Tax Rate Changes
      1. Deferred Tax Assets
         1. Arise from temporary differences where, initially, tax rules require smaller expenses or bigger revenues than GAAP
            1. Pre-tax income < Taxable income
            2. Income tax expense < Income tax payable
         2. In the future, GAAP will require smaller expenses or bigger revenues than tax rules
            1. Pre-tax income > Taxable income
            2. Income tax expense > Income tax payable
         3. The Deferred Tax Asset represents the benefit of tax savings in the future
         4. Example
            1. Brey Co. recognizes $80,000 of bad debt expense on 2010 sales. There are no write-offs of those sales in 2010. In 2011, Brey wrote-off $30,000 of accounts. In 2012, Brey wrote off $50,000 of accounts.
            2. 2010 Journal entry Dr. Income Tax Expense (+E) 7,000 Dr. Deferred Tax Asset (+A) 28,000 Cr. Income Tax Payable (+L) 35,000
            3. 2011 Journal entry Dr. Income Tax Expense (+E) 35,000 Cr. Deferred Tax Asset (-A) 10,500 Cr. Income Tax Payable (+L) 24,500
            4. 2012 Journal entry Dr. Income Tax Expense (+E) 35,000 Cr. Deferred Tax Asset (-A) 17,500 Cr. Income Tax Payable (+L) 17,500
            5. Temporary difference
            6. Timing of bad debt expense and tax expense is shifted across time
            7. But totals are the same between books and taxes
      2. Changes in Future Tax Rates
         1. Deferred tax assets and liabilities must be based on expected future tax rates
            1. Generally, assume that current tax rate will continue into the future
         2. If the government changes the statutory tax rate, the balances in DTA and DTL must be adjusted to reflect the new rate, with the adjustment running through Income Tax Expense
            1. Tax rate increase
            2. DTAs increase -> Dr. Deferred Tax Asset (+A), Cr. Income Tax Expense (-E)
            3. DTLs increase -> Dr. Income Tax Expense (+E), Cr. Deferred Tax Liability (+L)
            4. Tax rate decrease
            5. DTAs decrease -> Dr. Income Tax Expense (+E), Cr. Deferred Tax Asset (-A)
            6. DTLs decrease -> Dr. Deferred Tax Liability (-L), Cr. Income Tax Expense (-E)
      3. Example
         1. Deferred Tax Liabilities and Change in Tax Rates
            1. At the end of 2011, the government increases the tax rate to 40%
            2. Balance in DTL is $9,450 (under 35% rate)
            3. Pre-tax Difference = $9,450 / 0.35 = $27,000
            4. Note: this is the difference in Accumulated Depreciation (107,000 – 80,000)
            5. DTL at new rate = $27,000 x 0.40 = $10,800
            6. Required increase in DTL = $10,800 - $9,450 = $1,350 Dr. Income Tax Expense (+E) 1,350 Cr. Deferred Tax Liability (+L) 1,350
         2. Deferred Tax Assets and Change in Tax Rates
            1. At the end of 2011, the government increases the tax rate to 40%
            2. Balance in DTA is $17,500 (under 35% rate)
            3. Pre-tax Difference = $17,500 / 0.35 = $50,000
            4. DTA at new rate = $50,000 x 0.40 = $20,000
            5. Required increase in DTA = $20,000 - $17,500 = $2,500 Dr. Deferred Tax Asset (+A) 2,500 Cr. Income Tax Expense (-E) 2,500
   4. Valuation Allowances and NOLs
      1. Valuation Allowance
         1. Deferred Tax Assets represent future tax savings; i.e. a reduction in future cash outflows
         2. But, companies can only realize tax savings if they are profitable
            1. DTA reduces taxes paid, but will not produce a refund if the company does not have to pay taxes
            2. Companies do not have to pay taxes when they have negative taxable income
            3. Must have positive taxable income and positive income tax payable
         3. Companies can only report a Deferred Tax Asset if it is "more likely than not" the firm will be profitable enough in the future to take advantage of the tax savings
         4. If it is not "more likely than not", companies must reduce the DTA using a Valuation Allowance (XA)
            1. Works just like Allowance for Doubtful Accounts
      2. Net Operating Losses (NOLs)
         1. A net operating loss occurs in a year when taxable income is negative
         2. Federal tax law permits taxpayers to use an NOL to offset the profits of prior and future years
         3. First, carry the NOL back 2 years and receive refunds for income taxes that have already been paid in those years
         4. Any loss remaining after the 2-year carryback can be carried forward up to 20 years to offset future taxable income
         5. Create a Deferred Tax Asset for the amount of tax savings due to NOL Carryforwards
      3. Example
         1. NOLs
            1. In 2011, Noll International Inc. experienced an $80,000 net operating loss (i.e. negative taxable income) in its US subsidiary, and a $150,000 net operating loss in its Liechtenstein subsidiary
            2. Noll did not pay taxes in 2009-2010 in either jurisdiction, so it cannot carry the loss back to get a refund
            3. Noll expects it is "more likely than not" to be able to use NOL carryforwards in 2014 in both countries
            4. US tax rate is expected to be 35%. The US DTA is $80,000 x .35 = $28,000
            5. Liechtenstein tax rate is expected to be 15%. The LI DTA is $150,000 x .15 = $22,500
            6. Journal entry: Dr. Deferred Tax Asset (+A) 50,500 Cr. Income Tax Expense (-E) 50,500
         2. NOL Carryforwards and Valuation Allowance
            1. In June 2012, Noll is preparing its quarterly reports and has serious doubts about the future profitability of its Liechtenstein subsidiary
            2. Noll decides that it is not "more likely than not" to be able to use NOL carryforwards in Liechtenstein before they expire
            3. Recall, the LI DTA is $150,000 x .15 = $22,500
            4. Journal entry: Dr. Income Tax Expense (+E) 22,500 Cr. Valuation Allowance (+XA) 22,500
            5. Disclosure presentation
            6. Deferred Tax Assets DTA: NOL Carryforwards 50,500 Less Valuation Allowance (22,500) Net Deferred Tax Assets 28,000
            7. In December 2012, Noll is preparing its annual report and is now very optimistic about the future profitability of its Liechtenstein subsidiary
            8. Noll decides that it is "more likely than not" to be able to use NOL carryforwards in Liechtenstein by 2014
            9. Recall, the LI DTA is $150,000 x .15 = $22,500
            10. Journal entry: Dr. Valuation Allowance (-XA) 22,500 Cr. Income Tax Expense (-E) 22,500
            11. Note that this entry will increase Net Income by $22,500
            12. Such valuation allowance reductions could be used for "last chance" earnings manipulation
   5. Income Tax Disclosure Example
      1. Deferred Tax Footnotes
         1. Components of Income before Tax
            1. Domestic vs. Foreign
         2. Components of Income Tax Expense
            1. Currently payable vs. Deferred
         3. Reconciliation from Statutory to Effective Income Tax Rates
            1. Permanent differences
         4. Components of Deferred Tax Assets and Liabilities
            1. Temporary differences and Valuation Allowance
         5. Differences between Footnote and Balance Sheet
            1. Deferred tax assets and liabilities may be netted by jurisdiction on the balance sheet
            2. Deferred tax assets and liabilities may be split into current and noncurrent portions
      2. Disclosure Example
         1. Moth Inc. manufactures construction equipment
         2. Questions to answer from Moth's Income Tax footnote:
            1. What is the effect of Moth's non-US subsidiaries on its 2012 effective tax rate?
            2. Provide a summary journal entry for 2012 Income Tax Expense
            3. Provide the journal entry for the change in valuation allowance during 2011. Why did Moth make this entry? What effect does this entry have on net income?
            4. Was Moth's warranty expense for tax purposes higher or lower than its warranty expense for book purposes in 2012?
            5. Was Moth's depreciation expense for tax purposes higher or lower than its depreciation expense for book purposes in 2012?
         3. Footnote 6: Income Taxes
            1. Effect of non-US subsidiaries on 2012 ETR
            2. Increased ETR by 1.9%
            3. Represents extra tax on the same pre-tax income
            4. Permanent difference
            5. For tax calculations, we will use statutory rate: 35%
            6. Cash paid for income taxes (1)
            7. $306 in 2012
            8. Cr. Income Tax Payable 390 = (390 – 306) Cr. Cash 306 Cr. Inc Tax Pay 84
            9. Deferred Tax Assets (3)
            10. Debit of 120 (1916 – 1796)
            11. Deferred Tax Liab (3)
            12. Credit of 175 (521 – 346)
            13. Valuation Allowance (3)
            14. Credit of 11 (72 – 61)
            15. Journal entry for 2012 Income Tax Expense
            16. Dr. Income Tax Expense 455 Cr. Deferred Taxes 65 Cr. Income Tax Payable 390
            17. More detail?
            18. Dr. Income Tax Expense 455 Dr. Deferred Tax Assets 120 Cr. Deferred Tax Liabilities 175 Cr. Valuation Allowance 10 Cr. Income Tax Payable 84 Cr. Cash 306
            19. Cr. Def Taxes 65 = Dr. DTA 120 Cr. DTL 175 Cr. Val Allow 10
            20. Journal entry for 2011 change in valuation allowance
            21. Decrease of $68 (61 – 129)
            22. Dr. Val. Allow. (-XA) 68 Cr. Inc. Tax Exp. (-E) 68
            23. Increases Net Income by $68
            24. Why did the Valuation Allowance decrease?
            25. "circumstances changed at certain of our European subsidiaries"
            26. 2012 difference in Warranty Expense
            27. Warranty DTA increased by $43 (237 – 194)
            28. Dr. Income Tax Exp Dr. Deferred Tax Asset 43 Cr. Income Tax Payable
            29. Income Tax Expense < Income Tax Payable by $43 for Warranty
            30. Pre-tax Income < Taxable Income by $123 (43 / 0.35)
            31. Book Warranty Expense > Tax Warranty Expense by $123
            32. 2012 difference in Depreciation Expense
            33. Capital Assets DTL increased by $120 (383 – 263)
            34. Dr. Income Tax Exp Cr. Def Tax Liab 120 Cr. Income Tax Pay
            35. Income Tax Expense > Income Tax Payable by $120 for Depreciation
            36. Pre-tax Income > Taxable Income by $343 (120 / 0.35)
            37. Book Depreciation Expense < Tax Depreciation Expense by $343
   6. Taxes, SCF, and Marketable Securities
      1. Taxes and the Statement of Cash Flows
         1. All operating activity line items on the SCF are shown pre-tax
            1. All tax effects are reflected in:
            2. Changes in Deferred Taxes
            3. Changes in Income Tax Payable
         2. Example
            1. Company increases book Depreciation Expense by $100 in 2011
            2. Pre-tax income down by $100
            3. Income Tax Expense down by $35 (100 x .35)
            4. Net Income down by $65 (100 – 35)
            5. Tax Depreciation is unaffected
            6. Taxable Income unaffected; Income Tax Payable unaffected
            7. Balance these differences with a reduction in Deferred Tax Liability of $35
            8. Journal entries
            9. Dr. Depreciation Expense (+E) 100 Cr. Accumulated Depreciation (+XA) 100
            10. Dr. Deferred Tax Liability (-L) 35 Cr. Income Tax Expense (-E) 35 (100 x .35)
         3. SCF: Cash Flows from Operating Activities
      2. Taxes and Marketable Securities
         1. Gains or losses on Marketable Securities are taxed only when sold
            1. Tax is based on the difference between the sales price and the purchase price
         2. Trading Securities
            1. Unrealized gains/losses from mark-to-market are carried on the Income Statement
            2. Create a Deferred Tax Asset or Liability
         3. Available for Sale Securities
            1. Unrealized gains/losses for AFS securities are stored up in AOCI
            2. Accumulated Other Comprehensive Income must be carried on an after-tax basis
            3. Create a DTA or DTL to reflect the tax effect of the unrealized gains/losses in AOCI
         4. Example
            1. Trading
            2. Mark-to-market on balance sheet date
            3. At quarter end, Bott Bank's investment in TK stock is now worth $129 (Bott bought the stock for $100)
            4. Journal entries:
            5. Dr. Marketable Securities (+A) 29 Cr. Gain on Investments (+R) 29
            6. Dr. Income Tax Expense (+E) 10 (29 x 0.35) Cr. Deferred Tax Liability (+L) 10
            7. Note: No Income Tax Payable because taxes are only paid when the security is sold
            8. Sale of investment
            9. After quarter end, Bott Bank sells its TK stock for $109
            10. Journal entries:
            11. Dr. Cash (+A) 109 Dr. Loss on investment (+E) 20 Cr. Marketable Securities (-A) 129
            12. Dr. Deferred Tax Liability (-L) 10 Cr. Income Tax Expense (-E) 7 (20 x 0.35) Cr. Income Tax Payable (+L) 3 ((109-100) x 0.35)
            13. Note: Income Tax Payable is based on the Realized Gain computed using the original cost (109 – 100)
            14. AFS
            15. Mark-to-market on balance sheet date
            16. At quarter end, Meyer Co.'s investment in TK stock is now worth $129 (Meyer bought the stock for $100)
            17. Journal entries:
            18. Dr. Marketable Securities (+A) 29 Cr. AOCI (+SE) 29
            19. Dr. AOCI (-SE) 10 Cr. Deferred Tax Liability (+L) 10
            20. Note: Instead of debiting Income Tax Expense, as we would if this went on the Income Statement, we debit AOCI
            21. Sale of investment
            22. After quarter end, Meyer Co. sells its TK stock for $109
            23. Journal entries:
            24. Dr. Cash (+A) 109 Dr. AOCI (-SE) 29 Cr. Gain on investment (+R, +SE) 9 Cr. Marketable Securities (-A) 129
            25. Dr. Income Tax Expense (+E) 3 (9 x 0.35) Cr. Income Tax Payable (+L) 3
            26. Dr. Deferred Tax Liability (-L) 10 Cr. AOCI (+SE) 10
10. Shareholders' Equity
    1. Share Issuances and Repurchases
       1. Shareholders' Equity
          1. Shareholders' equity is the residual claim on assets after settling claims of creditors (i.e.assets-liabilities)
          2. Shareholders' equity due to share issuance:
             1. Contributed capital
             2. Common stock
             3. Preferred stock
             4. Treasury Stock
             5. Repurchased shares that may be reissued
          3. Shareholders' equity due to operations:
             1. Retained earnings
             2. End Retained Earnings = Beg Retained Earnings + Net Income – Dividends
             3. Accumulated Other Comprehensive Income
             4. Items that bypass the Income Statement
       2. Types of Stock
          1. Preferred stock
             1. Between debt holders and common stock holders in claim on assets
             2. No voting rights, but pay a fixed dividend that must be paid before common dividends
             3. May be callable, convertible, or redeemable
          2. Common Stock
             1. Voting rights, but residual claimant to assets
          3. Par Value
             1. Stated value on shares used to compute balance in Common Stock or Preferred Stock
          4. Additional Paid In Capital (APIC)
             1. Amount received in excess of par value
       3. Contributed Capital Terminology
          1. Shares Authorized
             1. Total number of shares the firm could issue
          2. Shares Issued
             1. Number of shares that have been sold to the public
             2. Balance in Common Stock at Par based on this amount
          3. Shares Outstanding
             1. Number of shares currently held by the public
             2. Shares issued minus “treasury shares”
             3. Dividends and Earnings Per Share based on this amount
          4. Example
             1. Issuing Stock - Preferred
             2. On 1/14/2012, Stack Inc. issued 10,000 shares of no-par preferred stock for proceeds of $7 per share. The preferred stock specifies cumulative $1 annual dividends per share.
             3. Journal entry 1/14/12 Dr. Cash (+A) 70,000 (10,000 x 7) Cr. Preferred Stock (+SE) 70,000
             4. Issuing Stock - Common
             5. On 1/14/2012, Stack Inc. issued 12,000 shares of $1 par value stock for proceeds of $10 per share
             6. ournal entry 1/14/12 Dr. Cash (+A) 120,000 (12,000 x 10) Cr. Common Stock (+SE) 12,000 (12,000 x 1) Cr. Add'l Paid in Capital (+SE) 108,000 (Plug)
             7. Shares issued: 12,000
             8. Shares outstanding: 12,000
       4. Share Repurchases and Treasury Stock
          1. Companies sometimes repurchase their own shares
          2. Repurchased shares are carried in the Treasury Stock (XSE) account
          3. Treasury stock does not have voting rights or dividend rights
          4. Treasury stock can be reissued by the firm
             1. Reissued treasury stock is removed from the Treasury Stock account at the original price paid to repurchase
             2. APIC or Retained Earnings are used to balance the journal entry if reissue price differs from repurchase price
             3. Companies cannot book gains or losses in trading in their own stock!
          5. Example
             1. Treasury Stock Purchase
             2. On 3/3/2012, Stack Inc. repurchased 4,000 shares of its common stock at a price of $11 per share
             3. Journal entry 3/3/12 Dr. Treasury Stock (+XSE) 44,000 (4,000 x 11) Cr. Cash (-A) 44,000
             4. Shares issued: 12,000
             5. Shares outstanding: 8,000
             6. Treasury Stock Sale – Price Increase
             7. On 4/4/2012, Stack Inc. sold 1,000 shares of its treasury stock at a price of $14 per share
             8. Journal entry 4/4/12 Dr. Cash (+A) 14,000 (1,000 x 14) Cr. Add'l Paid in Capital (+SE) 3,000 (Plug) Cr. Treasury Stock (-XSE) 11,000 (Original cost)
             9. Shares issued: 12,000
             10. Shares outstanding: 9,000
             11. Treasury Stock Sale – Price Decrease
             12. On 5/5/2012, Stack Inc. sold 1,000 shares of its treasury stock at a price of $9 per share
             13. Journal entry 5/5/12 Dr. Cash (+A) 9,000 (1,000 x 9) Dr. Add'l Paid in Capital (-SE) 2,000 (Plug) Cr. Treasury Stock (-XSE) 11,000 (Original cost)
             14. Shares issued: 12,000
             15. Shares outstanding: 10,000
             16. Note: if APIC has a zero balance, debit Retained Earnings
             17. Treasury Stock Retirement
             18. On 5/15/2012, Stack Inc. decided to retire 1,000 shares of its treasury stock
             19. Journal entry 5/15/12 Dr. Common Stock (-SE) 1,000 (1,000 x 1) Dr. Add'l Paid in Capital (-SE) 10,000 (Plug) Cr. Treasury Stock (-XSE) 11,000 (Original cost)
             20. Shares issued: 11,000
             21. Shares outstanding: 10,000
    2. Dividends, Splits, and AOCI
       1. Retained Earnings
          1. Retained Earnings: Cumulative income that has not been paid out as dividends
          2. Net income: Positive net income increases retained earnings; negative net income decreases retained earnings
          3. Dividends: Decrease retained earnings since this is a return of equity to shareholders
       2. Cash Dividends
          1. Declaration date
             1. Company declares a dividend will be paid to all investors that hold shares as of the ”date of record“ (e.g., 10 days after the declaration date)
          2. Date of record
             1. Date on which investors must hold shares to be entitled to receive the dividend
             2. An investor that sells shares after the record date is still entitled to receive the dividend
          3. Payment date
             1. Date on which the firm pays the dividend
          4. Note: Firms are not required to pay dividends. However, once a firm has declared a dividend, the firm is legally obligated to pay it to its shareholders as of the record date
             1. Create a liability called Dividends Payable
          5. Example
             1. On 6/6/2012, Stack Inc. declares a $0.50 dividend per share to both common and preferred shareholders of record on 6/16/2012. The dividend will be paid on 6/26/2012.
             2. Preferred shares issued and outstanding: 10,000
             3. Common shares issued: 11,000; Common shares outstanding: 10,000
             4. Journal entry
             5. 6/6/12 Dr. Retained Earnings (-SE) 10,000 (20,000 x .50) Cr. Dividends Payable (+L) 10,000
             6. 6/16/12 No entry
             7. 6/26/12 Dr. Dividends Payable (-L) 10,000 Cr. Cash (-A) 10,000
       3. Stock Dividends and Splits
          1. Stock dividend
             1. Each common shareholder is given a dividend in the form of new common shares
             2. Each stockholder's percentage ownership of the company will be identical to what it was before the stock dividend
             3. No cash flow involved
             4. If dividend less than 25%: reduce Retained Earnings and increase Common Stock and APIC using current market price of the shares
             5. If dividend greater than 25%: reduce Retained Earnings and increase Common Stock using the par value of the shares
             6. Example
             7. On 7/7/2012, Stack Inc. declared a 10% common stock dividend; i.e., every shareholder received new shares equal to 10% of current shares held. The price of Stack stock on 7/7/12 was $11 per share.
             8. Shares issued: 11,000; Shares outstanding: 10,000
             9. Dividend will be 1,000 shares (10,000 x .10)
             10. Journal entry
             11. 7/7/12 Dr. Retained Earnings (-SE) 11,000 (1,000 x 11) Cr. Common Stock (+SE) 1,000 (1,000 x 1) Cr. Add'l Paid in Capital (+SE) 10,000 (Plug)
             12. Shares issued: 12,000
             13. Shares outstanding: 11,000
          2. Stock spilt
             1. Each common share is replaced with a given number of new common shares
             2. No balance sheet, income statement, or cash flow effect
             3. Adjust number of shares authorized, issued, and outstanding, as well as the par value
             4. Example
             5. On 8/8/2012, Stack Inc. announces a 2-for-1 common stock split. Shares issued: 12,000; Shares outstanding: 11,000; Par value: $1
             6. Journal entry 8/8/12 No entry
             7. Shares issued: 24,000
             8. Shares outstanding: 22,000
             9. Par value: $0.50 per share
       4. Accumulated Other Comprehensive Income
          1. Debits ("expenses", "losses") and Credits ("revenues", "gains") that "bypass" the income statement and go directly into Shareholders' Equity
          2. Rationale: Companies do not like volatile earnings caused by market movements. Some accounting methods require marking assets/liabilities to fair value
             1. Unrealized gains and losses would cause volatility in Net Income
          3. Compromise: GAAP and IFRS require companies to mark-to-market, but allow unrealized gains/losses to bypass the income statement
             1. But, Balance Sheet must balance, so unrealized gains/losses go into Accumulated Other Comprehensive Income, instead of through Net Income into Retained Earnings
          4. Items go into AOCI on an after-tax basis
             1. Tax effect of item goes into a Deferred Tax account
       5. AOCI Items
          1. Unrealized Gains/Losses on Marketable Securities
             1. Under Available for Sale treatment, unrealized gains and losses from marking Marketable Securities to fair value are recorded in AOCI
          2. Foreign Currency Translation Adjustments
             1. Converting the assets and liabilities of foreign subsidiaries from the foreign currency to the domestic currency under the "Current Method" leads to unrealized gains and losses that go to AOCI
          3. Pensions
             1. The difference between the actual gains/losses on pension assets and the expected gains/losses on those assets goes to AOCI
          4. Derivatives
             1. For "Cash Flow Hedges", unrealized gains and losses from marking Derivatives to fair value are recorded in AOCI
       6. Statement of Shareholders' Equity
          1. Report the changes in all of the shareholders' equity accounts
             1. Presents beginning and ending balances in each account and shows all increases and decreases during the year
          2. Common Stock, APIC, Treasury Stock
             1. Issuances and repurchases of stock, stock-based compensation
          3. Retained Earnings
             1. Net income, Dividends, and some effects of stock-based compensation
          4. Accumulated Other Comprehensive Income
             1. All items that affect AOCI
          5. Noncontrolling Interest
             1. For consolidated subsidiaries with less than 100% ownership by company, noncontrolling interest shows the claims on net assets by outside owners in the subsidiaries
    3. Stock-based Compensation
       1. Restricted Stock Plans
          1. Companies pay employees with shares of stock as compensation
       2. Stock Option Plans
          1. Companies grant employees the right to purchase a number of shares at a fixed price (called the "exercise" or "strike" price) over a specified period of time (often 10 years) as compensation
          2. Most of the time, the exercise price is set equal to the stock price at the time the options are granted (called an "at-the-money" option)
       3. Generally some vesting period (normally 1-3 years) must pass before the employee is allowed to sell the stock or exercise the option
       4. The value of the restricted stock or options granted is treated as an expense and recognized over the vesting period
       5. Example
          1. Restricted Stock Grant
             1. On 1/1/2013, Stack Inc. grants 1,000 shares of stock to its CEO as compensation. The stock price is $20 per share on the grant date. The stock vests after two years. The par value is $0.50.
             2. Journal entry
             3. 1/1/13 Dr. Deferred comp. expense (+XSE) 20,000 (1000 x 20) Cr. Common Stock (+SE) 500 (1000 x .50) Cr. Add'l Paid in Capital (+SE) 19,500 (Plug)
          2. Restricted Stock Vesting
             1. Journal entries
             2. 12/31/13 Dr. Compensation expense (+E) 10,000 Cr. Deferred compensation expense (-XSE) 10,000
             3. 12/31/14 Dr. Compensation expense (+E) 10,000 Cr. Deferred compensation expense (-XSE) 10,000
          3. Stock Option Grant
             1. On 1/1/2013, Stack Inc. grants 100 options to its CFO with an exercise price of $20 as compensation. The options vest after two years and expire after 10 years. The stock price is $20 on the grant date. The fair value of the option is $18 per share at the grant date.
             2. Fair value of stock option grant is $1,800 (100 x $18). This will be amortized over the vesting period.
             3. Journal entries
             4. 12/31/13 Dr. Compensation expense (+E) 900 Cr. Add'l Paid in Capital (+SE) 900
             5. 12/31/14 Dr. Compensation expense (+E) 900 Cr. Add'l Paid in Capital (+SE) 900
          4. Stock Option Exercise
             1. On 6/6/2018, the CFO exercises the 100 options to buy the stock at the $20 exercise price. The market price of Stack's stock is $30 on that day. Stack re-issues treasury stock to provide the shares.
             2. The treasury stock was acquired at $11 per share
             3. Journal entry
             4. 6/6/2018 Dr. Cash (+A) 2,000 (100 x 20) Cr. Treasury Stock (-XSE) 1,100 (100 x 11) Cr. Add’l Paid-in-Capital (+SE) 900 (Plug)
             5. Note: The market price is not relevant for this journal entry, but Stack will get a tax deduction equal to ($30 - $20) x 100 shares = $1,000
             6. These tax savings are considered a Cash Flow from Financing
             7. This amount is taxable income for the CFO
    4. Earnings Per Share
       1. Basic
          1. EPS provides a measure of how much earnings was generated for each share of common stock held by outsiders
             1. Reported by the company at earnings announcement
             2. Forecasted by security analysts
             3. Compared to price per share to get "Price-Earnings" (P/E) Ratio
          2. Basic EPS = (Net Income – Preferred Dividends) / Weighted average number of common shares outstanding
          3. Example
             1. For the year ended 12/31/2013, Stack reported Net Income of $25,000. On 1/1/2013, Stack had 22,000 common shares outstanding and 10,000 preferred shares outstanding. Stack issued 4,000 common shares on 6/30/2013. Stack paid $5,000 of preferred dividends and $9,000 of common dividends during 2013
             2. Basic EPS = (Net Income – Preferred Dividends) / Wtd avg. number of common shares outstanding = (25,000 – 5,000) / (22,000 + (4,000 / 2)) = (25,000 – 5,000) / ((22,000 / 2) + (26,000 / 2)) = 20,000 / 24,000 = $0.83
       2. Earnings Per Share (EPS) – Diluted
          1. Companies with "complex" capital structures also report Diluted EPS
             1. Complex capital structures includes securities that can be converted into stock at the investor's discretion
             2. Convertible debt, stock options and warrants
             3. Some of the value of these convertible securities is tied to the value of common stock; thus, investors holding these securities are "indirect" stockholders
          2. Diluted EPS provides EPS assuming everything that could convert to a share of stock actually did so
          3. Diluted EPS = (Net Income – Preferred Dividends + Adj. for convertibles) / (Wtd avg num of common shares outstanding + Adj. for convertibles)
       3. Diluted EPS
          1. Convertible Debt
             1. Convertible debt can be exchanged for common stock
             2. Diluted EPS is computed under the assumption that the convertible debt had been exchanged for common stock at the start of the period
             3. This is called the "if converted" method
             4. Numerator of EPS: Net Income is increased by the after-tax interest expense on the convertible bond
             5. If debt had converted, there would have been no Interest Expense, so it is added back to Net Income
             6. Denominator of EPS: Number of shares is increased as if the debt was converted to common shares at the beginning of the period
             7. Example
             8. For fiscal year 2013, Stack’s Net Income of $25,000 included $500 of Interest Expense on convertible debt. The debt is convertible into 2000 shares of common stock. The statutory tax rate is 35%.
             9. Basic EPS = 20,000 / 24,000 = $0.83
             10. Diluted EPS = (20,000 + (500 x (1-.35))) / (24,000 + 2,000) = 20,325 / 26,000 = $0.78
          2. Stock Options
             1. "In-the-money" stock options give the holder the right to acquire a share of common stock at a pre-specified price
             2. Diluted EPS is computed under the assumption that a fraction of the options had converted to common shares
             3. This is called the "treasury stock" method
             4. Numerator of EPS: No adjustment necessary
             5. Denominator of EPS: Number of shares is increased by a fraction of each outstanding option
             6. Number of additional shares = Number of options x Conversion fraction
             7. Conversion fraction = (Avg. Stock Price – Exercise Price) / Avg. Stock Price
             8. Example
             9. During fiscal year 2013, Stack had 1,000 outstanding in-the-money options with an average exercise price of $10. The average stock price during the year was $20.
             10. Conversion fraction= (20 -10) / 20 = 0.5
             11. Diluted EPS (Conv. Debt only) = 20,325 / 26,000 = $0.78
             12. Diluted EPS = (20,325 + 0) / (26,000 + (1,000 x 0.5)) = 20,325 / 26,500= $0.77
          3. Complications
             1. Diluted EPS must always be less than or equal to Basic EPS
             2. Diluted EPS is set equal to Basic EPS in years when a firm has a loss from continuing operations to common stockholders
             3. If Diluted EPS would be greater than Basic EPS after a convertible is added to the calculation, the convertible is considered "antidilutive" and is excluded from computation of Diluted EPS
             4. Options are considered "antidilutive" when the exercise price is greater than the market price (i.e., when the option is "out of the money").
    5. Contributed Capital Disclosure Example
       1. PupCo manufactures health drinks for dogs and cats
       2. Questions to answer from PupCo's Shareholders' Equity disclosures:
          1. What are shares issued, shares outstanding, and par value for common stock?
          2. How much cash did PupCo get from issuing new shares in 2012?
          3. How much cash dividends were declared and paid in 2012?
          4. How much did PupCo pay to repurchase shares in 2012? What was the average price?
          5. What is the average price paid to acquire all treasury shares held at 12/31/2012?
       3. (1) Balance Sheet - Shareholders' Equity
          1. Shares issued 1,865
          2. Shares outstanding
             1. Issued: 1,865 - Less Treasury: 284 = Outstanding: 1,581
          3. Par value 5/3 cents ($0.01667)
       4. (2) Statement of Shareholders' Equity – Preferred and Common Stock
          1. New stock issuance
             1. Common Stock: $1 + APIC: $4,546 = Total: $4,547
       5. (3) SCF – Cash from Financing Section
          1. But, no Cash Flow from issuing shares
          2. Cash from new stock issuance = $0
          3. Disclosure at bottom of SCF: Shares were issued for acquisition (a noncash activity)
       6. (4) Statement of Shareholders' Equity – Retained Earnings and AOCI
          1. Cash dividends declared
             1. Common: $3,022 + Preferred: 1 + RSUs: 12 = Total: $3,035
          2. Cash dividends paid
             1. Total: $2,978
       7. (5) Statement of Shareholders' Equity – Repurchased Stock
          1. 2012 payments to repurchase shares $4,978
          2. 2012 average price = $4,978 / 76 = $65.50
          3. Average price all treasury shares held at 12/31/2012 =$16,745 / 284 = $58.96
    6. Stock-based Compensation Disclosure Example
       1. PupCo manufactures health drinks for dogs and cats
       2. Questions to answer from PupCo's Stock-based Compensation and EPS disclosures:
          1. What are the terms of PupCo's stock options (e.g., exercise price, vesting period, length)?
          2. What was the total fair value of stock options granted in 2012?
          3. How much was stock-based compensation expense in 2012?
          4. How much cash did PupCo receive from options exercised in 2012? What was the source of the stock sold to employees exercising options?
          5. What type of convertibles caused Diluted EPS to be less than Basic EPS in 2012?
       3. (6) Note 6 — Stock-Based Compensation
          1. Our stock-based compensation program is designed to attract and retain employees while also aligning employees’ interests with the interests of our shareholders. Stock options and restricted stock units (RSU) are granted to employees under the shareholder-approved Long-Term Incentive Plan (LTIP). We account for our employee stock options under the fair value method using a Black-Scholes valuation model. All stock option grants have an exercise price equal to the fair market value of our common stock on the date of grant and generally have a 10-year term. The fair value of stock option grants is amortized to expense over the vesting period, generally three years. RSU expense is based on the fair value of PupCo stock on the date of grant and is amortized over the vesting period, generally three years. Each RSU is settled in a share of our stock after the vesting period.
             1. Stock option terms
             2. Exercise price
             3. Equal to stock price at grant date
             4. Length
             5. 10 years
             6. Vesting
             7. 3 years
             8. Valuation for accounting purposes
             9. Fair value based on Black-Scholes model
          2. Fair value of 2012 option grants
             1. Num. granted: 26,858 x Fair value: $13.93 = Total FV: $374,132
          3. Cash from exercise (3)
             1. Num. exercised: 23,940 x Avg. Price: 43.47 = Total Cash: $1,041
          4. Source of stock
             1. Treasury shares: $1,487 (5)
             2. Avg price = $61.96
             3. ($1,487 / 24)
       4. (7) Statement of Shareholders' Equity – Preferred and Common Stock
          1. (8) SCF – Cash from Operations Section
          2. Stock-based comp expense in 2012 $299
       5. Note 11 — Earnings per Common Share
          1. Basic earnings per share is net income available for common shareholders divided by the weighted average of common shares outstanding during the period. Diluted earnings per share is calculated using the weighted average of common shares outstanding adjusted to include the effect that would occur if in-the-money employee stock options were exercised and RSUs and preferred shares were converted into common shares. Options to purchase 24.4 million shares in 2012 and 39.0 million shares in 2011 were not included in the calculation of diluted earnings per common share because these options were out-of-the-money.
          2. Why Diluted EPS < Basic EPS
             1. Convertible preferred stock
             2. Stock options and RSUs
             3. But note than many more options are out-of-the-money!