Accounting

Professor Brotman Fall 2001

12, 5 pt mult choice; 10, 6pt short answer (more than questions o not e!en ha!e "#s on them$
%eep in min &'F()(*(+),-- *hat we spent time on in class. Because those will li%el/ 0e on there.
1oo%in2 at ol e3ams is not that 2reat of an iea the quantitati!e issues ha!e 0een 2reatl/ e4
emphasi5e. 2o throu2h answers that Brotman hane out 0ut, no real nee to re!iew each
answer %e/. 6eat of the e3am comes from last 7 or 8 wee%s of the course
&e0it 9reit
:ssets 1ia0ilities ; +wner#s 'quit/
1. Introduction to GAAP - Generally Accepted Accounting Principles - result of choices
made by Financial Accounting Standards Board (FASB - independent body but close
to accounting profession)
REVENUE is the monetary amount of annual sales, including returned merchandise and discounts, i.e., it is the
top monetary figure from which costs are subtracted to determine net income.
a. Diferent sources of GAAP
1. F:,B
2. ,'9< */picall/ aopts =::P, e3cept when ,'9 e>nes accountin2 principles, in
which case accountin2 profession aopts ,'9 principle. ,'9 has the power
since it ma%es the rules for the e3chan2e of securities
b. What is GAAP? Four objectives:
2. accuracy/reliability (trustworthy statements ! (nfo nees to 0e an
accurate s/stem; no mathematical errors.
3. I.e. Statements should be erifiable and tested free from mathematical bias or
calculation bias.
1
MEMORIZE!
Assets, Expenses = Debit Accounts = Left Hand Accounts/Entries
Liabilities, Owners Euit!, Re"enues = #redit Accounts = Ri$%t Hand Accounts/Entries
=
??"#$enses are an intra$erio% %ecrease in owner&s e'uity, an therefore,
the/ are &'B(* accounts 0ecause owner#s equit/ is a @i2ht4han sie
0alance, therefore, e3penses appear on the 1eft4han sie 0ecause the/
must 0e creite a2ainst owner#s equit/.
(()evenues are intra*$erio% increases in owner+s e'uity, an therefore, the/ are
4. relevance (timely basis ! requires that info 0e recore an presente on
a timel/ 0asis so that it ma/ 0e use to forecast future performance an
to ai in unerstanin2 past performance.
5. !.g. "he definition of #ecession analogy$%e do not %ant a situation %here %e
finally &no% that %e '!#! in a recession( ) %ee&s after it is already oer.
6. com$arability creatin2 a s/stem that ena0les a reaer of >nancial
statements to compare<
a$ e3ternal compara0ilit/< (a0le to e!aluate compan/ a2ainst other
companies$ an;
0$ internal compara0ilit/< compare a corp to itself o!er time (0oo% calls
this consistenc/
7. consistency (must use the same accountin, metho%s from year to year-
@equires ,ta0ilit/ i.e. the entit/ shoul use the same accountin2
methos /ear to /ear. Accom$lishe% throu,h
8. *+"!, Brot suggests that %e are currently in a period %hre stability is irreparably
damagted because corps hae ignored -AA.. /uarterly earning reports are not the
-AA. 01s( but rather( 01s that include certain -AA. features.
9. !.g. *ortel *et%or&s( last 2uarter( they too& a 345B %rite-off( but assessed it as a one-
time charge. S+66
./ $rinci$les:
Separate Entity Assumption 4 entit/ 0ein2 reporte on is re2are as istinct
from those who own it, whether or not it is a separate entit/ for le2al purposes.
Going Concern Assumption 4 entit/ will 0e operatin2 ine>nitel/. )ot 2oin2 to
liquiate or terminate operations 9ritical to unerstanin2 the cost principle.
:ssumes that assets are 0ein2 use for the 0usiness an not for other purposes.
Time Period Principle 4 entities acti!ities can 0e clearl/ i!ie into separate time
perios, such as monthl/, quarterl/, or /earl/.
atc!ing Principle must allocate to the proper time perio.
a. (tems of re!enue allocate to the perio urin2 which eAort was
e3pene in 2eneratin2 them; an
b. (tems of e3pense will 0e allocate to the perio in which 0ene>t from
them will contri0ute to 2eneratin2 re!enue.
c. Bse accrual accountin2 not cash accountin2. ,o eals with the wealth
of the compan/, not its cash Cow. '3. Pro0lem " D in 2:. (nterest
e3pense oes not accrue until ne3t month. 6a/ ha!e to aEust later
for /ear perio report.
d. i.e. match e3penses with relate re!enue when the 0ene>t is
reco2ni5e
e. 'F. )G Ballet 9o si2ns a 0allet star with a !er/ si2ni>cant 0onus pai
in G1 of H in her contract. @e!enue associate with this e3pense will
0e pai o!er H /ears. I'G< re!enue is not alwa/s equal to cash
e3peniture an receipt.
onetary Transactions Principle 4 6ust 0e 0ase on actual transactions. *his is
wh/ 2oowill is not t/picall/ recore on 0alance sheet 0ecause it is not irectl/ tie
to a reco2ni5a0le transaction. (n orer to recor a transaction, the earnin2s process
must 0e suJcientl/ complete. =::P 2enerall/ follows the title principle of law. '3.
2
Pro0lem " H in 2: for when orers are cancela0le at an/ time. ,o /ou onl/ recor
transactions that can use monetar/ units to measure the actual transaction
"ecognition Principle 4 items of re!enue shoul 0e reco2ni5e onl/ when the entit/
has complete or !irtuall/ complete the e3chan2e that 2enerates the income.
,houl not treat somethin2 as earnin2s until the earnin2s process is complete.
Principle o# Conser$atism 4 Bnerstate, rather than o!erstate, earnin2s, etc.
e3ample< use of historical cost is conser!ati!e.
Cost Principle 4 assets to 0e reporte at historical rather than (hi2her$ mar%et cost.
*his is a hallmar% of >nancial accountin2. ,ee the K2oin2 concernL assumption.
Because of the 2oin2 concern assumption, ta%e into account the usefulness of the
asset assets reporte at historical cost.
o '3. (B6 0u/s 0l2 in Mestchester in 1N80 for O16. @eport at cost e!en if the
propert/ appreciates urin2 term of ownership 0ecause the compan/ 0ou2ht it
to help with the 0usiness an not to ma%e mone/. +therwise, we woul 0e
assumin2 a liquiation an instea we assume a 2oin2 concern. :ppreciation
an epreciation of the 0uilin2 is not rele!ant to a computer corp who oes
not sell real estate assumin2 the 2oin2 concern principle.
a. 9ertain t/pes of assets ma%e this reall/ important. "01"P23456:
i. 9ash 4 unless there was an oJcial e!aluation that B, ne!er ha.
ii. 6ar%eta0le ,ecurities 4 F:,B ecie that since certain of these
ha!e such imme%iate li'ui%ation value, it woul 0e improper not to
treat them as mar%et !alue (F6P$. :ssets coul 0e for use as cash
equi!alents
b. =enerall/, on#t !alue assets at mar%et 0ecause pro0lems of appraisal
an F6P not rele!ant.
Consistency 4 Mithin a set of >nancial statements, appl/ principles consistentl/
(prefer not to pic% an choose$.
ateriality 4 (nfo to 0e reCecte in >nancial statements shoul 0e meanin2ful to
users an not too tri!ial. *his is important 0ecause somethin2 can 0e ini!iuall/
unimportant 0ut !er/ important to a22re2ate (e2, sale of one pac% of ci2arettes is
not si2ni>cant to the to0acco co, 0ut the o!erall sales are si2ni>cant$.
1%. Unmentioned Principle, disclose eerything
a. 1om$onents of Financial 6tatements
1. &alance S!eet 4 li%e a snapshot of entit/ at an/ one point in time. 1ists
assets an lia0ilities of a compan/ as of a ,iven %ate- (ntene to reCect the
>nancial conition of that entit/ as of that speci>c ate (what it owns an
owes$. :ssets, lia0ilities, equit/ (e>ne as the resiual interest in assets of
an entit/ after su0tractin2 its lia0ilities$. :s a matter of con!ention, assets are
liste on the 0alance sheet in orer of liquiit/. A'()*E.
+. Assets< *hin2s of equit/ !alue that the compan/ owns (coul prouce
future economic 0ene>ts$. '!er/ asset is either creitor equit/ or owner
equit/. F:,BQs &e>nition< pro0a0le future economic 0ene>ts o0taine or
controlle 0/ an entit/ resultin2 from past transactions or e!ents. )ote
that all assets are reall/ prepai e3penses.
For e!er/ asset there is a cost.
3
9urrent :ssets< cash R cash equi!alents, :ccounts @ecei!a0le (:R@$,
(n!entories, prepai e3penses (li%e rent$. 'mplo/ees are not 2enerall/
consiere assets, thou2h the/ ma/ 0e when, for e3ample, when a
sports team 0u/s a contract.
11. Inesting in the training of a future baseball player li&e 7anny Almonte( this
technically fits the definition of an asset( but( %e don1t li&e to tal& about pple as
assets because of slaery.
1,. *+"!, #esearch and 7eelopment 8osts that 7rug 8o1s allocate to deeloping ne%
drugs are *+" an asset.
1on2 *erm :ssets< lan, 0uilin2s R impro!ements, >3tures R equipment,
transportation equipment, propert/ uner capital lease
=oowill 4 wh/ woul /ou pa/ more than F6P of assets for coS
compan/ has somethin2 that e3cees asset !alue (s/ner2/, reputation,
relationship$. 6eans +)1G the e3cess of purchase price o!er F6P of
net assets in 0usiness com0ination usin2 the $urchase metho% of
accountin2. ,a/in2 K=oowillL loo%s much 0etter on 0alance sheet
than sa/in2 Kloo% how much we o!erpaiL.
"a# '3. 6, woul 0u/ another compan/ to cut competition. :0ilit/ to use
names of assets is important (traemar%s$. But, since we onl/ recor
costs, the !alue of name woul not appear with an/ !alue on the 0alance
sheets 0ut woul 0e inclue in price if sol.
"b# ,ome !alua0le assets on#t appear on compan/#s >nancial accountin2
0oo%s< people (Bill =ates$, name (9o%e$.
+. (ia+ilities<
pro0a0le future sacri>ces of economic 0ene>ts arisin2 from present
o0li2ations to transfer assets R rener ser!ices in the future.
current lia0ilities
(a$ )otes Pa/a0le
(0$ :ccounts Pa/a0le (:RP$
(c$ accrue ta3es
($ contin2ent lia0ilities (O owe if stanars are not met$
13. )+ Tu2ment Get i.e. there is no lia0ilit/ G'*, thus, must ma%e a
etermination to consiuer whether it is li%el/ enou2h to consier it a
lia0ilit/ e!en thou2h it has not /et occurre.
1-. 'FUFor 6otor 9orp< an Firestone *ires, the/ pa/ to co!er Marranties;
this is thus an e3 of an e3pense that ma/ or ma/ not come ue, 0ut, in a
2i!en /ear, it is possi0le to estimate how much /ou will owe.
(a$ prepai e3penses (tuition for semester pai in :u2ust$
(0$ warrant/ costs ue in future
(c$ 0ons issue 0/ the corporation &e0t securities, i.e. KBons
Pa/a0leL
($ mort2a2es
(e$ lon24term e0t ue within one /ear
(f$ o0li2ations uner capital leases ue within one /ear
(2$ eferre re!enue (ser!ices R 2oos to 0e pro!ie$
lon2 term lia0ilities
(a$ lon24term e0t
(0$ 'mplo/ee @etirement Plans 0ut, there are uncertain an require
actuarial anal/sis;
(c$ lon24term capital lease o0li2ations
($ eferre income ta3es
(e$ eferre re!enue (ser!ices R 2oos to 0e pro!ie$
4
+. *.ner/s E0uity<
resiual interest in assets of entit/ after su0tractin2 its lia0ilities from
its assets. 'quit/ represents the net ownership interest in the entit/. (t
represents 0oth initial in!estments mae 0/ the entit/Qs owners an
entit/Qs increases in income that it rein!ests in the 0usiness. *here are
two cate2ories here 4 contri0ute R pai4in capital (O e3chan2e for
shares$ an retaine earnin2s (O R earnin2s %ept in the compan/ an
not pai out to ,VQs$.
(a$ preferre stoc%
(0$ common stoc%
(c$ capital in e3cess of par !alue
($ @etaine 'arnin2s (@'$
2. 1ncome Statement 23Statement o# *perations45 3P 6 (47 4 1i%e a motion
picture pro>t W loss statement, statement of operations; statement of
re!enue an e3penses. @eCects performance of the entit/ %urin, a $erio% of
time (e.2., 1 /r$. 1ists re!enues 2enerate urin2 the perio an total
e3penses incurre urin2 that perio. *he/ also show the iAerence 0etween
these two items. &iAerence 0etween re!enue an e3pense urin2 each
reportin2 perio is calle entit/#s net income for the perio.
a. F:,BQs e>nitions
(1$ @e!enues X increases in equit/ resultin2 from asset increases an or
lia0ilit/ ecreases from eli!erin2 2oos or ser!ices that constitute the
entit/Qs on2oin2 maEor or central operations. )evenues are intra*$erio%
increases in owner+s e'uity- '3amples inclue< sales of merchanise,
renerin2 of ser!ices, sales of securities 0/ a securities ealer R of
0uilin2s 0/ a real estate e!eloper, i!iens an interest earne 0/
>nancial institutions.
(2$ '3penses X ecreases in equit/ from asset ecreases or lia0ilit/
increases from eli!erin2 2oos or ser!ices or carr/in2 out an/
acti!ities which constitute the entit/Qs maEor or central operations.
"#$enses are intra*$erio% %ecreases in owner+s e'uity. '3amples< cost
of 2oos manufacture an sol, sellin2 an aministrati!e costs, an
interest e3pense of >nancial institutions.
0. +!er!iew
(1$ @e!enue X increase in equit/
(2$ '3penses X ecrease in equit/
(H$ @e!enues o not equal receipts (i.e., :R@$
(D$ '3penses o not equal e3penitures (i.e., :RP$
c. :ccounts<
(1$ '3pense :ccounts (temporar/$
a. 9+=,
0. @esearch '3pense
c. 1i0rar/ '3pense
. @ent '3pense
(2$ @e!enue :ccounts (temporar/$
a. ,ales
0. Fee (ncome (ser!ices$
5
$. Statement o# "etained Earnings4 Vistorical recor of the portion of net
income (earnin2s$ not pai out to owners. For e3ample 4 statement that lists
the 0e2innin2 0alance in retaine income, followe 0/ a escription of an/
chan2es that occurre urin2 the perio an the enin2 0alance. *his is not
require 0/ =::P, 0ut is require 0/ the ,'9 for all pu0lic companies.
%. Statement o# Cas! 8lo.s 4 6otion picture too. 1ists the total 9:,V that
Cowe in W out of entit/. @econciles 0alance sheet an income statement.
9ash is important 0ecause creitors an emplo/ees e3pect to 0e pai. *his
statement is use to etermine if entit/ can 2enerate enou2h earnin2s to pa/
its o0li2ations. @econciles income statement with the 0alance sheet an tries
to 2i!e more info on where cash was spent urin2 the 2i!en /ear or quarter.
)ote that this oes not e3plain how the compan/ 2enerates (or loses$ cash. (t
Eust etails the Cow of cash.
'.2. &ot com K0urn4rateL how fast can /ou 0urn /our cash.
&. 8ootnotes 4 6ost information a0out >nancial conition of entit/ a!aila0le in
income statement, 0alance sheet an statement cash Cows. Mhere not
suJcient, footnotes can ela0orate an e3plain information therein (e2, 1oss
contin2encies$.
c. Au%itor&s )es$osibilities: to loo7 over all of the
com$any+s 8nancial statements an% %etermine how
accurate they were- Au%its the 8nancial statements of
the com$any an% o$ines whether these 8nancial
statements are $resente% in accor%ance with GAAP-
1. Auditor9s "eport 4 :ll pu0lic entities are require 0/ feeral securities laws to
2et these.
2. anagement (etter 4 :uitor issues a separate letter to entit/#s
mana2ement. *hese letters a!ise the entit/#s mana2ement of an/
wea%nesses isco!ere in internal control mechanisms, etc.

d. 9y$o * 6: Partnershi$ %issolution * only asset is
buil%in, * cost ;<=- ;>//7 owe%- A$$raisal says fair
mar7et value is ;?=@ 5A1 a$$raisal ;>= (for $ro$
ta#es@ an% ;B//7 ta# basis-
1. Y< Mhich !alue o /ou useS 'ach partner woul want to 2et 0ac% more than
put in (0ene>t from appreciation$.
2. Mhat oes !alue meanS 'ach of these num0ers reCects a certain !alue.
@easona0le people isa2ree. Purpose< value has a lot of %iferent meanin,s.
'ach one correctl/ ienti>es a t/pe of !alue. 1aw/er woul loo% to parties#
intent for !alue an accountant woul loo% to cost.
$. =::P< Financial accountin2 loo%s to ha!e a s/stem of reportin2 an recorin2
>nancial transactions. =::P is a set of rules 0/ which >nancial accountin2 is
2o!erne (not laws$. ,'9 (le2al force$ has its reportin2 requirements for each
compan/ on quarterl/, /earl/ an on as4occurre 0ases. ,'9 2enerall/ efers
to =::P for its requirements. ,i2ni>cant o!erlap 0ecause ,'9 2uielines are
usuall/ incorporate 0/ =::P.
6
II. 2he Fun%amental "'uation: Assets ' (ia+ilities ) *.ner9s E0uity
Rearranged algebraically!
' ( ) * OE
E+. If own house or car , how much is it worth , how much do I owe on it * the amt that I own.
IM- R.)E ! e/erything that we do M.01 2EE- 13I0 E4.'1IO5 I5 6')'57E
'. Funamental 'quation 4
1. :ou+le Entry &oo;;eeping 4 left sie of equation must alwa/s 0e equal to the
ri2ht sie. *herefore, there are 2 entries for e!er/ transaction to 0e accounte
for.
a. Debit X Ceft 6i%e "ntry. :n entr/ that increases assets or ecreases lia0ilities.
:s !er0, means increase left or ecrease ri2ht sie (??of funamental
equation$. (&ecrease lia0ilit/ X to e0it, e.2. :ccounts Pa/a0le$. &e0it
accounts inclue<
:ssets
'3penses
b. 1re%it X @i2ht ,ie 'ntr/. :n entr/ that ecreases assets or increases
lia0ilities. :s !er0, ecrease left or increase ri2ht sie (??of funamental
equation$. (&ecrease asset X to creit, e.2. 9ash$. 9reit :ccounts inclue<
(1$ 1ia0ilities
(2$ +wner 'quit/ 4 on creit sie of funamental equation. Balances will
alwa/s 0e creits.
(H$ @e!enues
c. 's a matter of boo88eeping, treat items of re/enue and e+pense separately and reflect them as
subcategories of owner9s e:uity portion of fundamental e:uation.
d. IM-OR1'51 '00.M-1IO5! every asset a company owns has a claim against it "creditors ;
owners claims ( liabilities ; owners e:uity#.
')<'=0 M.01 3O5OR 13E >.5?'ME51') E4.'1IO5 , if increase a left hand
side balance, must decrease the right hand side acct.
1o 7redit@ therefore could mean either! to increase the right hand side acct or to decrease
the left hand side acct.
e. :ssets thin2s of equit/ !alue that a compan/ owns< F:,B e>nition
pro0a0le future economic 0ene>ts o0taine or controlle 0/ an entit/ resultin2
from past transactions or e!ents
(1$ accounts recei!a0le
furniture
7
B/S A = L + OE
Left Right Left Right Left Right
(+) (-) (-) (+) (-) (+)
I/S Expenses + Revenue
Left Right Right Left
(+) (-) (-) (+)

eq cash 2
sa!es 2
n"te# i/s $ during a period of time c"ve%s ti&e 'et(een B/S) an* B/S2
1o ?ebit * to increase the left hand side acct
1o credit * to increase the right hand side acct
machiner/
in!entor/
cash
6. Tournal 'ntries 4 p. 1N. Boo% of ori2inal entr/. &e0its X 9reits 2al.ays7.
1. Debit / Credit 4 &e0its must alwa/s equal creits.
a. '3. 9ash transaction 4 want to see all cash transactions at once.
K+ne owner in!este O10% in the compan/.L
Tournal 'ntr/<
9ash O10,000
+wner 'quit/ O10,000
Mhat happene< the asset, cash, a e0it account, was increase. +wners#
'quit/, a creit account, was creite 4 increases the creit account.
2. Owners Equity (OE) (or SH equity) 4 +n creit sie of funamental equation.
Balances will alwa/s 0e creits. ,o in a0o!e e3ample we creite, on the ri2ht
sie, ownerQs equit/ in the amount of O10,000.
a- 4wner "'uity D )evenues * "#$enses
@e!enues increase (creit$ ownerQs equit/, so the entr/ 2oes on the ri2ht sie.
'3penses ecrease ownerQs equit/, so the entr/ 2oes on the left sie (e0it
0alance$. *V(, (, : =++& M:G *+ @'6'6B'@ MV'@' *+ PB* @'P')B', :)&
'FP'),',
<atergate 1heory of 'coounting , always >ollow the Money.
-roblem 2a. A ; A Inc. p. 2%
1 , Aac8 pays B&CCC to A ; A in e+change for 1CC shares of A ; A stoc8.
'ssets "7ash# increased by the amt of the in/estment, B&CCC, "and# OE Dthe common stoc8E increased by
B&CCC.
1' 7ash B&CCC
7ommon 0toc8 B&CCC
16 )and B&CCC
7ommon 0toc8 B&CCC
2 0upplies B12CC
'ccounts -ayable B12CC
% )oan BFCCC
5ote -ayable BFCCC
& E:uipment B&CCC
7ash B&CCC
F 'ccounts -ayable B%CC
7ash B%CCG
H 5ote Recei/eable B&CC
E:uipment B&CC "because we lost this from our debitIassets#
G 5ote , we are crediting an account with a left hand side balance therefore, we subtract here
7. 9reatin2 the Balance ,heet 4 @eCects 0e2innin2 R en of perio. :ccrual Basis of
:ccountin2 (mi2ht 0e cash, mi2ht not$.
1. <ournali=e 4 :t the en of each perio, Eournal entries 2et poste to the le2er
(we use * :ccounts$. :lwa/s ientif/ where the entr/ came from. *o o this, we
ma%e 0oo% entr/ for ori2inal transactions.
o Aournal also * Jboo8 of original entryK
o If do something financially, need to write it down here.
8
2. A ; A buys tools supplies and a large tent from '67 0upplies for B12CC charging
the purchase to its account. Assets increased b! &'()) wort% of supplies and
t%e! incurred &'()) of liabilities in t%e for* of pro*ise to pa! in t%e future
$. A ; A orders B&CCC worth of products from Lenon, that it e+pects will last until ne+t
0pring. 1he terms of the order permit A ; A to cancel the order without any obligation
Not%in$ %appens + no obli$ations,no effect on eit%er side of t%e account-
%. 'ssets increased by BFCCC "loan# , as of 1O?'=, e/en if there is 5O prepayment
option, because of the matching principle there is 5O treatment of the interest of BFCC in
this 'ccount because nothing has happened yet. 5ote payable of BFCCC
H. 0elling E:uipment "assets#@ Metting
asset in terms of notes recei/eable
1ransaction , i.e. credit card, cash payments.
5on(transaction , i.e. passage of time. E+. interest accrues e/ery month e/en though may
not ha/e interest due each month
2. Post (to 1e2er$4 we ta%e separate Eournal entries an put them into the
appropriate accounts.
)edger * boo8 of accounts, start to put things where they belong.
7hec8boo8 is a cash ledger , e/erytime that ha/e a transaction that effects cash ,
depositIwithdrawalIwriting a chec8.
H. Ad>usting entries are then mae in orer to reCect economic su0stance that has
occurre without aEustment. '3amples inclue interest an epreciation. *he
aEustin2 entries (for e3ample, aition of interest$ aAect the accounts. :lso,
mista%es nee to 0e aEuste. *his is a wa/ to account for acti!ities that occur
without a transaction chan2es that reCect time or iAerent circumstances
for e3ample, a pre4pai e3pense; or accrue 0ut unpai interest
D. Close 4 close out accounts throu2h temporar/ accounts. @e!enue is onl/ a
re!enue for a 2i!en perio. *herefore, the re!enue for 1NN7 oes not inclue an/
re!enues 2enerate in 1NN6. @e!enue an e3pense accounts are temporar/
accounts. Me close them out an put them in permanent ownerQs equit/ accounts
throu2h the Pro>t an 1oss :ccounts (P W 1 :ccounts$. ()ote that assets an
lia0ilities are also permanent accounts$
-ermanent
o 'ssets, liabibily and shareholders e:uity
1emporary
o Income and e+pense , measured temporally and after the gi/en period of time is o/er,
must start o/er again. I.e. <hen =ear 2CC1 starts, must start accounts o/er , for that
year you ha/e not earned anything yet "i.e. Aanuary 1
st
2CC1#.
5. Pro?t and (oss Accounts 4 ,tep 0efore postin2 entries to permanent accounts.
&o not ha!e to use these accounts, 0ut /ou can (no theoretical meanin2$.
a. 2he P E C account is an owner+s e'uity account@ use% tem$orarily for closin,
$ur$oses only. +nl/ temporar/ accounts 2o into the P W 1 account.
0. @etaine 'arnin2s :ccount< accumulate re!enues an e3penses. @' is
permanent account so want to use P W 1 as mechanical account where close
re!enues an e3penses. Process results in net amount in the permanent account.
6. Vow it wor%s<
Remember that temporary accts are re/enue and e+pense accts for that period. 1herefore, for the period, the
re/enue and e+pense accounts must be JNero(edK out in order to close out the temporary accts and mo/ing those
accounts into 0hare3olders E:uity
o Re/enues are Intra(period I57RE'0E in 0hareholders E:uity
9
+se ,-L acc"unt '. &"ving eve%.thing f%"& te&p"%a%. acc"unts int" it#
, an* L
/
/
/
0!"sing 1"u%na! Ent%ies exa&p!e#
Revenues 2222
,-L 2222
,-L 2222
Expenses2222
34E5#
,-L 2222
Retaine* Ea%nings/OE 2222
o E+penses are Intra(period ?E7RE'0E0 in 0hareholders E:uity.
7losing out the re/enue and e+pense accts will accomplish this
't the end of the period, the re/enue and e+pense accts should be Nero, ha/ing mo/ed those
sums into the retained earnings acct.
7. :fter accounts are close, /ou can 2enerate >nancial statements. :lwa/s start
with 9ash.
8. )ote on @e!enues an '3penses 4 ,ee Pro0lem 2B. :ccountin2 is a0out re!enues
an e3penses. =::P is not 0ase on cash.
a. "e$enue 4 &oes not mean receipt of cash. For e3ample, Bloomin2ale#s has
re!enue when /ou char2e on their creit car, 0ut not cash.
b. E@pense 4 &oes not mean e3peniture. 9har2e on B4ales car. '3pense is
not incurre until there is a le2al o0li2ation to pa/. '3pense is a utili5ation of
assets in the conuct of 0usiness.
N. @e!iew on ,tatements<
a. Tournali5e
0. 1e2er
c. *rial 0alance
. :Eustin2 writin2 own economic e!ents that occurre wRo transaction
e. 9losin2 2ettin2 re!enues an e3penses oA the 0oo%s
10. )ote< it is possi0le to en a perio with a ne2ati!e re!enue 0alance. For
e3ample, a retailer who ens his /ear with a return will ha!e a ne2ati!e 0alance
in his re!enue account. (t is also possi0le to ha!e a ne2ati!e e3pense.
10
)) Ba!ance Sheet# hea*ing has th%ee !ines
1-16 Inc
Ba!ance Sheet
As "f 1u!. 7)6 )888
Assets
0ash
A/R
,,E
3"ta! Assets
2222
2222
2222
2222
Lia'i!ities
5/A/,
3"ta! Lia'i!ities
O(ne%s Equit.
OE
3"ta! OE
3"ta! Lia'/OE
2222
2222
2222
2222
2222
2) Inc"&e State&ent
1-16 Inc9
Inc"&e State&ent
August6 )888
:ee Inc"&e 2222
Expense 2222
5et Inc"&e 2222
Accrual System o# AccountingA
1ash v- Accrual Accountin, * Accrual an% %eferral are critical elements of GAAP- 9ash
Basis accountin2 !iolates the matchin2 principal- )evenues are not recei$ts an%
e#$enses are not e#$en%itures
1. @eco2nition 4 Mhen enou2h has happene to recor it in 0oo%s an
recors. *he Ph/sical act of recorin2 transaction. '3. transaction, pa/ cash
for in!entor/ X reco2nition.
15. @eali5ation 4 the conclusion that, for purposes of implementing the matching principle,
some item of re/enue or e+pense associated with the transaction should be allocated to a
period other than the one in which the transaction occurs and is recogniNed. @eali5e
re!enue or e3pense out of transaction. Mhen, uner the matchin2
principle, some item of re!enue or e3pense associate with some
transaction shoul 0e allocate to a perio other than the one when the
transaction occurs an is reco2ni5e. *his is when some economic e!ent
is recore onto the income statement. Funamental element to show
whether the earnin2s process is complete.
a. '3amples<
'as/ e3 (cash purchase of t! 4 reco2nition W reali5ation
simultaneous$.
&iJcult e3 (O2000 pai for t!, t! to 0e eli!ere ne3t *ues. (s the
accountin2 process completeS *ou2h to sa/ 0ecause on#t %now if
3 can cancel the transaction throu2h a refun, etc$. Vas title
passeS compan/ has mone/ 0ut also still has in!entor/. Vin2es
on title. (nustr/ practice is !er/ important here.
V/po< ,ometimes custom is to recor orers 0efore fruit
har!este. (e.2. fruit cannin2 inustr/$. &isclosure is important
for =::P.
V/po< 9omcast 9a0le 4 Tan thru &ec accounts. ,ports seasons
can run throu2h cutoA. ,eason tic%et mone/ pai in ,ept. &o
/ou reco2ni5e all re!enue at this pointS 'arnin2s process not
complete 0ecause season ser!ices are split o!er 2 /ears. :lso,
pa/ pla/ers, etc o!er course of 2 seasons.
@etail< 6ost retail companies en their >scal /ear in Tanuar/ or
Fe0ruar/ 0ecause the/ ha!e hu2e !olumes (of sales$ in Tanuar/
an hu2e returns in Tanuar/. *herefore, the/ want sales an
returns matche for season, not the calenar /ear. *his also
ma%es it easier to ta%e ph/sical in!entor/.
1B. Accrual and de#erralA eman compan/ reco2ni5es its earnin2s c/cle
(equal >scal /ears$.
:ccrual< the concet o! recordin" a transaction #E$O%E
the cash co&es in. @eco2ni5e re!enue 0efore ha!in2 receipt of
11
pa/ment. @eco2ni5e e3pense 0efore e3peniture (e.2., ta3es not
pai until :pril$. :ccruals 2enerall/ occur when /ou must
reco2ni5e an e3pense thou2h /ou ha!e not /et pai for it. (ncur
o0li2ation to pa/. 'conomic e!ent has occurre 0ut for
pa/ment. . E+. 6orrow B and at the end of the financial period, interest is
owed on the principal. Reflecting that interest is owed, will be JaccruingK the
e+pense. I.e. recording the e+pense 6E>ORE it is paid.
1C. 5ow, on October 1C
th
, many companies are finally announcing their earnings for $
rd
:uarter(end "0ept $C
th
# 1his is an e+ample of an accrual because they wanted to wait for any
chec8s to bounce, etc 0o, they did not record or announce cashIre/enue that came in until
later.
(a$ '3ample< *heatre 9ompan/ pai after pro!iin2 D shows
1. @eali5ation
:R@ 100
@e!enue 100
18. .ut on first sho%
2. @eco2nition
9ash 100
:R@ 100
Accrued Expense: .tility 6illI-hone 6ill@ 1a+es. <hat economic benefit occurred such that we had to accrue
these e+penses.
Materiality! whether it is material@ would a reasonable person belie/e it to be significant <hen
companies are audited, different entities ha/e different thresholds of materiality.
'nother e+ample of something that re:uires an accrual are ta+es. 6ecause, must show the e+pense for
the year in which the it relates. >or e+ample, don9t report to the IR0 until 'pril 1&
th
for the pre/ious
year.
=et another e+ample of an accrued expense is a credit card, but, they are a little bit different "because it
is not an adOustment#.
(2$ &eferral< NOT recording the revenue that you have already received; or,
Deferred Expense: in the sense of an e+pense, a Jpre*paidK e+pense, that you
ha/e paid, but you will use up the benefit in the future. E+. -re(paying rent and
then getting to use the apartment for the entire month. -repaid E+penses are
'ssets.
Deferred Revenue: i.e. cash that you ha/e recei/ed, but you ha/e not pro/ided
goods or ser/ices until later, this is a liability because you owe someone
something in the future. ?eferred re/enues are liabilities.
"eceipt .it!out re$enue and e@penditure .it!out
e@pense. &efer reali5ation of re!enue until earnin2s are
recei!e. *his occurs when a transaction is not /et reali5e e!en
thou2h cash, in respect of that e!ent, is pai or recei!e in that
perio. &eferral is the notion that /ou ha!e recei!e or spent
somethin2 0efore it is appropriate to recor it. For e3ample,
when mone/ is refuna0le. @eceipt of cash that must later 0e
eferre is a lia0ilit/. @e!enue recei!e in a!ance is a lia0ilit/.
12
*his 2enerall/ occurs when /ou recei!e cash an o not want to
recor it /et. &eferre income is unreali5e re!enue. *his is a
lia0ilit/ 0ecause /ou either ha!e to o the ser!ice or return the
mone/. ()ote 4 prepai e3pense is an asset.$
(a$ '3ample< @ent an apartment. Bsuall/ /ou pa/ in a!ance 0ut /ou
ha!e not /et incurre the e3pense (0ecause /ou ha!e not /et
occupie for that month$. )+*'< *his is an accepte eparture from
=::P.
(0$ '3ample< @ecor inustr/. Mhen recor store 0u/s recors from the
la0el, the/ usuall/ ha!e a ri2ht of return for 100Z refun. V/po<
Marner sells 100,000 at O5 each. *ower pa/s at eli!er/. Vow much
re!enue oes M reco2ni5eS (n theor/, M cannot full/ reco2ni5e for
the sale until the en of the return perio. Vowe!er, throu2h
estimates, inustr/ custom W preicta0ilit/, M coul recor
somethin2. (f there is a reasona0le 0asis from e3perience as to how
much will not 0e returne, than the compan/ can recor 0ase on
estimate from historical practice. (f there is no historical practice,
wait until en of returns perio an then ta0ulate on the 0asis of
what actuall/ happene. *hen, if there are returns from *ower, /ou
%now what has happene an /ou can reali5e the re!enue. *his is
an e3ample of the principle of conser!atism 0ecause here we ten
to 0e conser!ati!e !ersus optimistic. Gou can alwa/s ma%e
aEustments later. (??6a%e sure to unerstan the iAerence
0etween reco2nition an reali5ation in practice$??.
(c$ &eferre (ncome *a3 X asset
($ '3ample< Bu/ D show tic%ets in a!ance<
1. reco2ni5e
Prepai 'ntertainment '3pense D00
9ash D00
2. reali5e (after attenin2 >rst show$
'ntertainment '3pense 100
Prepai 'ntertainment '3pense 100
H. *his is an e3ample of %eferral %eferrin, realiFation on
reco,niFe% transactions.
D. &eferral is the opposite of accrual realiFe before
reco,niFable event has occurre%.
Deferred Revenue: for e+ample, cash that you ha/e recei/ed but ha/e not rendered the good or ser/ice for that
yet.
E+. Micro0trategy , software consulting company.
o 0igned 29s to perform wor8 and then boo8ed it before they performed the wor8 "which failed
to reflect the costs that they would later incur by actually performing the wor8#. 1hey did this
to demonstrate that they were ma8ing re/enue.
o Other 7o9s paid Micro0trategy cash for the license to use the software e/en though the
ser/ices were owed in the future and the licenses were not secured yet, the 0oftware was yet to
be de/eloped, or, where it was de/eloped they would ha/e to twea8 it for a gi/en customer.
Ps.
Micro0oft! ' different approach.
o 0old software operating systems and made the determination that they were gi/ing a license,
and decided to treat 2I$
rd
s of the re/enue as deferred re/enue , as a part of the earning cycle.
o Micro0oft was criticiNed for being too conser/ati/e@ and insuring that they would ha/e
re/enue in the future. 1hey were able to manipulate and manage what the accounting
information says. E/en with Micro0oft, perhaps the re/enues were not what they appeared ,
13
they may ha/e actually been higher at present time "and inflated later on#. 1hey started doing
this in 1QQ%IQ& and re/olutioniNed the mar8et with <indows Q&.
o 1hey had 5O idea that e/eryone would buy new computers and were worried that they would
get 0o much B now and feared a huge re/enue drop(off in the future.
o 1herefore, they de/eloped the concept of spreading the re/enue o/er an e+pected cycle to
ma8e it seem li8e the re/enue was more stable. E/entually, this did not come to pass and the
deferred re/enue account grew so high that people began to loo8 at them coc8(eyed.
-hiladelphia E'M)E tic8et holders , 0tadium 6uilder )icense "06)# with the license you ha/e the rt
to use your seatsIbuy those seats for a period of 2C years. Eagles are ma8ing fans pay for these o/er a
period of years. 1he Eagles will ha/e to defer that re/enue o/er a period of 2C years. 1he benefit to
the 06) holder will be o/er the ne+t 2C years, i.e. the Eagles will be obligated to pro/ide the benefit
for the period of 2C years.
'ttorney9s Retainers as it relates to this e+ample. "RR#
o Earned Retainer! an initial retainer, a minimum fee that the lawyer has no obligation to return.
=ou get to 8eep it regardless of how much or little wor8 is done for it. 6rot belie/es that this
I0 recorded as re/enue, upfront, but, is not sure conceptually of how to wor8 this.
(2$ :ccrual an eferral eal with !ariations an Eu2ment issues.
:nother critical element is that /ou can win up with reall/
iAerent assumptions. *here are not necessaril/ ri2ht or wron2
answers here. 9ompanies ten to 2o with Kreasona0le estimatesL
X hi2hest amount auitor will si2n oA on unless /ou %now it#s
wron2. :uit process allows for a lot of ne2otiation as to what the
compan/ can 2et awa/ with reportin2.
(H$ Deferre% revenue is a liability pa/ment is recei!e in e3chan2e
for a commitment to eli!er 2oosRser!ices in future
(a$ 6icrosoft efers re!enue sell Minows for O120
1$ Gear 1
9ash 120
@e!enue D0
&eferre @e!enue 80 X ser!ice the/ are 2oin2 to
pro!ie
2$ Gear 2
&eferre @e!enue 80
@e!enue 80
E+amples! ObOecti/e of accrual de/ice * benefiting the income statement for the period in which the wor8 was
done. 'chie/e by using only balance sheet accounts in respect of the cash payment and then using income
statement accounts when the wor8 is actually done.
>or deferral e/ents the cash payment precedes the economic e/ent
>or accrual e/ents, the economic e/ent precedes the cash payment.
5O1E! Often an issue in accrual and deferral is when legal title passes from the seller to the buyer. 'ccounting
follows these general rules of when the transaction is complete.
J>O6 0hippingK means , the title has passed once the goods are passed to the shipping company@ i,e, if
the goods are lost during shipping, the buyer is liable.
o E+. 0omeone from 0eattle selling something to someone in 5=, and they put it on the plane,
then, at that moment, for them, the sale is complete. 1his is a big :uestion for the 7-' e+am.
J>O6 ?estinationK , 1itle does not change hands from buyer to seller until destination is reached.

14
.rice/line-co*, i-e- 01rot*an2s 3poster/bo!2 for bad accountin$ practices4 + not that they are illegal or not
M''-, but Oust that they do not ma8e sense. Internet tra/el pro/ider and their gimmic8 is Jname your own priceK,
if they are able to find you a tic8et that meets your :ualifications, your credit card gets automatically charged and
the card is charged the moment they accept your bid.
>rom their perspecti/e, they chec8 their database to see if something is a/ailable. 'nd, at the moment
that you get notified, they charge your credit card. 1heir arrangement with the airlines is a fi+ed
amount.
I.e. -hila to 7hicago they call sell for BH$ and they get BH& from you. 1he surplus
goes directly to 'R7, a clearhouse that di/ies upIdistributes the B, i.e. pay ta+es, their
own fee, the airline, and then -riceline
o 7ontrast! calling Rosenbluth tra/el, when tic8et is purchased credit card says J?eltaK.
3owe/er, -riceline, is the 5erc%ant of Record, who appears on your credit cardI
-riceline is the Jmerchant of recordK ((S i.e. the ris8 of loss is on -riceline "where the credit card is
bad or you try to bac8(charge#.
-riceline treats the entire BH& as re/enue. 6ecause they are the merchant of record and bear the intial
loss, they treat the entire amt as re/enue, e/en though they do no e/en get to 8eep close to the BH& of
re/enue. 1hey, thus, were showing that they had tremendous amount of re/enue.
o I.e. they would say we made B16illion whereas they only had BQCM "Q percent of the
announced re/enue#.
'lso, in order to drum up business for students, sometimes, if you would bid BH& and the best price
was BTC, they would pay the difference on a not insignificant amount of tic8ets. In these cases they
were 01I)) recording the BH& as re/enue e/en though they were actually reimbursing the airlines B&
and running a loss on that transaction.
-OI51! this is allowed within M''-, e/en though 6rotman says it is legal, but bullshit,
nonetheless. 6%erefore, i*portant fro* a business perspecti"e for in"estin$, to note accrued and
deferred expenses- Reall! need to loo7 at t%in$s ualitati"el! as a law!er w%en doin$ an 8.O for
a co*pan!- 0E7 will issue comments in letters during I-Os. )awyers should be the critical
professional ad/isor intimately in/ol/ed for the client.
.roble* '9


?ebits U 7redits
1$a# 0ecurity ?eposit B1&C
7ash B1&C
1$a# A subscribed for cell phone ser/ices from 5yne+
and paid 5yne+ a refundable security deposit of B1&C
in repsct of the cell phone
1$b# -hone E+pense B&C
-hone -ayable B&C
1$b# ?uring 'ugust, A incurred phone charges of B&C,
for which it is billed on 0ept 1C, payment due on Oct
1C,
1%# Interest E+pense B&C
Interest -ayable B&C
1%# Interest accrued on the note due to 7ityban8 "F2
note at &VIyear#
1&# -repaid Insurance B12CC
7ash B12CC
1&# A purchased a liability insurance policy paying a
premium of B1,2CC for co/erage from 'ug 1 thru Aan
$1
st

1&G# Ins E+pense "'ug# B2CC
-repaid Ins B2CC
5O1E! this is an adOusting entry to reflect that we ha/e
used the benefit of prepaid insurance for 1 of the
months.
1F# 6onus E+pense BHCC
6onus e+p payable BHCC
1F# A became obligated to pay Aac8 and Aill bonuses of
B$CC and B%CC, respecti/ely, per their ,ee agreements
1H# 7ash! B2CC
.nearned Re/enue B2CC
1H# A agreed to pro/ide repair s/cs to the members of a
local club, beginning 0ept 1, at a monthly fee of B2CC.
club paid B2CC in ad/ance as its 0ept fee
1T# In/entory B1CCC
7ash B1CCC
1T# A paid B1CCC for tires and tubes it plans to resell ,
the tires and tubes were deli/ered.
15
Remember, accrued e+penses
are ?E6I1 accts and deferred
e+penses increase liabilities.
, EnOoyed econ benefit before
had to pay.
'lso, not rele/ant what day
bill recei/ed or due, Must
record for period during
which e+penses were
incurred.
1his is a Deferred Expense ,
i.e. pay for it, but will use the
benefit in the future ,
deferred e+penses are assets
Deferred Re"enue ,
which is a liabilit!. 1his
is the Micro(0trategies
e+ample, abo/e
Daluation Principles
'. Time Dalue o# oney 4 the principle that O1 toa/ is worth more than O1 tomorrow.
&ue to inCation, an amount of mone/ toa/ is worth less than that amount of mone/
at some future time. :ccountin2 2enerall/ fails to ta%e into account this !aluation
information. 100 ollars toa/, is worth 10H ollars if the interest rate is HZ 44
interest is what /ou pa/ to use someone elses OO.
1nterest !as , componentsA
(nCation rate the interest /ou ma%e on the O /ou len out shoul 0eat the inCation
rate or else /ou woul not len the OO in the >rst place
Btilit/ or, :I:, the Kreal interest rateL 44 Feeral Funs @ate the rate at which the
feeral reser!e char2es other 0an%s to 0orrow on an o!erni2ht 0asis (that was 5.5Z a
/ear a2o$; 0ut, the real interest rate was SS
o @ea2an runnin2 for re4election in 1N8D :r2ues that interest rates ha!e fallen
tremenousl/ an that has 0een 2reat for :merica (the prime rate was, in
1N80 21Z, whereas in 1N8D it went own to 12Z[howe!er, 6onale note
that t!e real interest rate was actuall/ hi2her than it ha e!er 0een
0ecause of Bu2et &e>cit which cause the interest rate to 2o up (n 1N8D the
inCation rate was 1HZ, 0ut, the nominal interest rate was NZ 44 therefore, the
real interest rate was DZ (hi2her than it ha e!er 0een.
Spread< the iAerence 0Rw the ris%4free rate an the mar%et rate the 1
thin2 consiere to 0e ris%4free is the B, *reasur/ Bon (nstrument
(there is no ris% associate with this$ :11 that /ou are 0ein2
compensate for is the time !alue of OO an a nominal transactional
cost. (f 0u/in2 an instrument from 9iti0an%, there is some t/pe of
premium for ta%in2 that ris% so, the iAerence in the 9ommercial 1oan
interest return an the B, *reasur/ is the spread
E@. ortgage 1nterest "ates 0e2innin2 of 2001 when the 10
/ear mort2a2e was !er/ 1+M (wei2hte a!era2e maturit/ of
6ort2a2es went wa/ own from 5.75Z to D.5Z 44 0ut, the actual
chan2e in 6ort2a2e rate was less onl/ .5Z$[this create
,P@':&
1nterest ta;es a.ay $alue (+)1G not true when there is a
eCationar/ perio an a ne2ati!e interest rate$. (.e. eAecti!el/, urin2
all perios, prices rise therefore, interest ta%es awa/ !alue 0ecause
thin2s will 0e more !aluea0le in the future.
+cto0er For 6otor 9ars Billion &ollar &e0t +Aerin2<
o (6P+@*:)*< aspect of 0on is its pricin2 i.e. its coupon
rate.
@oa ,how< ma%e a presentation to potential
in!estors for equit/ or e0t oAerin2 in orer to len
crei0ilit/ to the in!estment an put a face 0ehin
the oAerin2. For 2oes out to sell ONBillion of Bons
at 7Z (time4la2 0Rw re2istrerin2 the 0ons an
16
<e want to ?E6I1
"increase# '00E1 acct of
in/entory for B1CCC
?ecrease '00E1 of cash
for B1CCC by crediting it.
sellin2 them$ the interest rate that pple are willin2
to pa/ for the Bon is 7.1Z
10 Gears; 7Z; O1,000 44\ what if in!estors as%
for the 0ons at the 7.1Z interest rateS *he
price of the 0ons will 2o own as interest
rate 2yield7 goes up5 t!e price goes
do.n. As interest rates go do.n5 price
o# +onds go up.
*his is important in accountin2 0ecause
most 9o#s o not issue the 0on at par i.e.
face !alue. 44\ if For sells the 0ons :* P:@,
then, the interest rate has )+* chan2e at all
Ui.e. it has sta/e at 7Z. *his almost ne!er
happens 0ecause, on a ONB 0on oAerin2 a
chan2e in the interest rate of .01Z is worth
ON6.
:iscountA when /ou pa/ or recei!e less than
face !alue. (f interest rates ha!e 2one up, the
iAerence in the price is name the discount.
2i.e. the compan/ issue 0ons for ONN0
instea of O1000$
o EEF PTA (e$el Field the interest
rate that an instrument is sol at or
issueR )+* its face !alue this is
amorti5e o!er the life of the loan
where, e!er/ /ear, the person will 2et
O70R/ear o!er 10 /ears to total O1000U
the e3tra O10 represents the chan2e in
interest rate on the a/ /ou purchase
the 0on. 2he interest rate is base% on
how the instrument was $rice% on the
%ay of issuance at the issue rate an%
542 the face value ! i-e- in this case@ if
the interest rate ,oes u$ to G-.H@ then
the bon% is issue% at a %iscount an% the
G-.H level yiel% is use% to %etermine
the $ayments you receive-
*riginal 1ssue :iscount
23*1:47 this means that /ou will
0e ta3e on re!enue that /ou o
not recei!e until later on. *his
was to counteract cheatin2
throu2h a loophole in the 1N80#s
interest /ielin2 instruments
issue at a P'@G low price
(2ettin2 )+ return on their
in!estment for 10 /ears then,
2ettin2 the return 0ase on
capital 2ains (6B9V 1',, than$
at the rich pple#s mar2inal rate.
Premium< when /ou pa/ or recei!e more than
face !alue this is 2oo if /ou are the 0u/er of
the 0on.
17
o '3treme e3ample< a 1 /ear 0on
toa/, can 0u/ it for O1000 (1 /ear until
maturit/$ therefore, 1 /ear from
toa/, /ou 2et O1100. (f e!er/one else
is willin2 to 2i!e /ou a 20Z interest rate
i.e. 1200 1 /ear from now. :s% self<
now, how much less o ( ha!e to in!est
to /iel O1100 (much less than O1000$.
o Pension Funs or (nsurance 9ompanies
ma/ 0u/ 0ons (nsurance 9o >2ures
out when /ou are suppose to ie an
then 0u/s a 0on, an annuit/.
@e2istration ,tatement< meetin2 ,tate Blue4,%/
>lin2s e!en for pri!ate placements.
o VGP+< 10R2NR01 Brot; sa/s it e3poses some of the e>cinies in accountin2.
*hat :ccountin2 oes not ta%e into account that *ime Palue of OO, 0ecomes a
B(= pro0lem when /ou are in a perio of much hi2her inCation )+*'<
Be2innin2 of 1N80 where the price of 2asoline e3ploe an the inCation rate
went cra5/ in 1N80 it was at 20Z when, in 1N82 it was 1DZ (in a perio of D4
5 /ears, prices ou0le, an, in a /ear of 24H /ears, prices went up 50Z 44 *his
0ecomes an issue 0ecause /ou ha!e in!entor/ that /ou ma/ 0e holin2 for 10
months therefore, for prices to increase 20Z (li%e in 1N80 when it went up
that much in 1 /ear$, it woul normall/ ta%e H45 /ears to increase that amount.
:nother Mea%ness '3ample< Vi2h4Palue low mar2in 0usiness (sell a lot
of prouct, 0ut, o not ma%e a lot on each sale$ i.e. ma%e le2al pas
an sell 206 of them 1 month sell 16 per month an ma%e O.10 on
each. 44\ (ma2ine that /ou ma%e the 10Z mar2in an /ou#re in an
en!ironment in which prices are increasin2 20Z per month. From an
accountin2 p.o.!. that is )+* reCecte. :ccountin2 ma%es )+ eAort to
istin2uish 0Rw ou0lin2 /our OO in 1 /ear or in 15 /ears. 44
19. Mh/ o people 2enerall/ prefer earlier pa/ment of mone/ to eferre
pa/mentS
a. Btilit/ 4 (mmeiate possession of the thin2 satis>es immeiate esire.
b. @is% 4 @is% of non4pa/ment of future sum.
c. +pportunit/ 9ost 44 some opportunities are mutuall/ e3clusice[ 44 what
amount of O to 0e pai in the future woul lea /ou or most pple to opt
for future sum instea of the present sum.
Present Dalue tells us what the ri2ht to recei!e a certain sum at some point in the
future is worth to us toa/. :n, allows us to etermine the rate of return we will recei!e on
our in!estment if we anticipate recei!in2 a particular sum of O in the future. B/ eterminin2
the present $alue of an in!estment we can compare it not only .it! t!e rig!t to
recei$e a sum o# G today5 +ut .it! t!e present $alue o# ot!er in$estments t!at
are a$aila+le to us.
2. (nterest @ates< at a certain le!el, the cost of mone/ is the interest rate.
a. Base @ate 4 component of (nterest rate that compensates for inCation.
*here is no pro>t here, Eust full repa/ment of a e0t owe. Business people
nee to 0e a0le to compare cash Cows, compare opportunities. '3.
,omeone lens O1000 toa/. (f HZ inCation, when /ou pa/ them 0ac% in 1
/ear, the/ nee OH0 more.
18
b. @eal @ate<
1$ @is%.
2$ (nCation
a$ minimum interest char2e has to equal rate of inCation
0$ real interest rate is rate without inCation rate factore in (SS$
H$ 9ost of 6one/
a$ ris% that inCation will increase
0$ cost of transaction
c$ ina0ilit/ to use the mone/ for somethin2 else
D$ :ccountin2 i2nores interest rates Me use historic cost instea of
mar%et !aluation
c. 9oncept of Present Ialue allows !aluation in unerstana0le, compara0le
wa/ 0/ con!ertin2 future pa/ment to !alue toa/. *herefore, /ou can
unerstan what a pa/ment of O5000 in 5 /ears woul 0e worth to /ou
toa/.
d. 9ompoun interest< earn interest on the interest
6. 8uture Dalue 4 Mhat a ollar sa!e toa/ is worth in n /ears. Mhat is the FP of OF
in n /ears, usin2 interest rate of IZ ],ee *a0les ch. 10^
1.
Formula< FPn X 3 (1 ; %$
n
] FB*B@' P:1B' F:9*+@^
3 X amount starte with;
% X interest rate;
n X num0er of /ears
44 )ote that the hi,her the interest rate@ the ,reater the future value ??
44 Bse the formula or Eust refer to the ta0les in the 0oo% at p. 18H. *o use the
ta0le, Eust
multipl/ F 0/ !alue on ta0le.
2.
9ompounin2 H earn interest on interest that /ou ha!e accrue o!er time (part of
computin2 future !alue$. FPn X 3 (1 ; %Rm$
mn
m X num0er of times per /r interest will 0e pai;
mn X num0er of times compounin2 will occur,
so if semiannual, i!ie %R2 an multipl/ n(2$.
a. '3ample< F wants to 0u/ O1000 item in one /ear. Vow much O oes F nee
toa/ to ha!e to 2et itS
FP X O1000, interest rate (%$ X 10Z, n X 1, 3X S
3 ; .13 X 1000; 1.13 X 1000; 3 X N0N ()ote that no ta3es are assume
here.$
b. 9an still use chart, Eust aEust Z an perios (0/ usin2 mn !s. n$
c. Future Palue will 0e hi2her if compoune more than annuall/ 0ecause
each time /ou calculate the !alue, /ou ha!e a hi2her num0er from which to
0e2in the ne3t calculation.
7. Present Dalue 4 *ells us what the ri2ht to recei!e a certain sum at some point in the
future is worth toa/. *a%e pa/ments that will occur in future, iscount for PP an
calculate how much the/ are worth toa/. ] Mhat is the PP of OF to 0e recei!e at
en of /ear n, assumin2 iscount rate of %Z^
1. Formula< PP X 3n R (1 ; %$
n
]P@',')* P:1B' F:9*+@^
% X iscount rate
19
,%. "he higher the discount rate( the lo%er the present alue.
,1. 8alculate this according to the formula or use the table at p. 9:9 and ;ust multiply <
by the number gien in the table.
,,. .= %ill be lo%er if compounding is done more fre2uently than annually.
2. Present Palue of an :nnuit/ (ie, present !alue of a stream of pa/ments$ ]Mhat is
the PP of the ri2ht to recei!e OF at en of each of the ne3t n /ears, assumin2 a
iscount rate of %Z^
@n I 21 ) ;7
n

a. (f an in!estment contains a lump sum an a promise of an annuit/, then use
ta0le (p. 181$ for lump sum component an ta0le (p. 18H$ for the annuit/
component. *V') a the two PP#s to2ether. 44 )ote the H steps here.
b. &onds< compan/ sa/s it will pa/ /ou a certain amount of mone/. (f interest
rates 2o own, present !alue 2oes up an if /ou onl/ want an 8Z return on
mone/, /ou can in!est more than O1000R/r 0ecause still woul 2et O100R/r at
8Z (an O1250R/r$. Bons o well when interest rates fall.
c. )ee to separatel/ account for those amounts. Mhen /ou >2ure a 0on, >2ure
lump sum an annuit/, then a them to2ether. :nnuit/ X O100R/r, e!er/ /r
for 10 /rs. 9onstant, re2ular.
d. *o compare in!estment alternati!es, nee to 0e a0le to reuce to present
!alue. :lso, the hi2her the interest rate, the lower the PP an !ice !ersa.
=::PQs wea%ness R failure is that it is in nominal ollars (historical price$. Me
on#t chan2e the 0alance sheet to recalculate recei!a0les at new present
!alue.
e. PP is o0Eecti!e (mathematical certaint/$, whereas appraisals are su0Eecti!e.
H. Compounding and Present Dalues 4 PP X 3n R (1 ; %Rm$
mn
n X 2 , PP X 3, % X 10Z, FP X 1000
3 ; .13 ; (.13 (1.13$$ so 3 X O826 (essentiall/ N0N482.60$.
*he more time /ou ha!e, the less /ou ha!e to sa!e.
a. 6ost critical factor< Vi2her the interest rate (price to use O$, less O /ou 2et
to %eep. 6ore /ou pa/ for interest, the more present !alue eclines. :s
interest eclines, present !alue increases.
b. e3. if % X 8Z, PP will 0e hi2her than if 10Z.
&. T!e "ule o# C,/s<
1. *o etermine how lon2 it ta%es to ou0le /our mone/, /ou can i!ie the
num0er 72 0/ the rate of return.
2. *herefore, if /ou assume a rate of 8Z, then it ta%es N /ears to ou0le /our
mone/.
H. (f /ou i!ie 72 0/ the num0er of perios, /ou 2et the interest rate it ta%es to
ou0le /our mone/ in that amount of time.
D. *his wor%s most accuratel/ at the center of the cur!e (84N R N48$.
'. Mhen assets are not interest 0earin2, we ten not to account for future an
present !alue. *his is true e!en thou2h an amount contracte for now ma/ 0e
worth less 0/ the time it is ultimatel/ pai.
So' i! you contracted to recei(e ) !or your ser(ices o(er ti&e and "ot )*++,
u !ront and )*+, each o! the ne-t . years' how wou/d interest rate a0ect
that 1 i.e. it is 2O3 worth the entire )*6+, 444
1JDEJT*"F CKAPTE" -

20
A- Boo%%eepin2 (ssues 4 '!olution of B.,. into manufacturin2 societ/ create a nee for
accountants 0ecause of concerns a0out the Cow of 2oos. :ccountin2 assumptions
a0out in!entor/ o not necessaril/ correspon to Cow of 2oos. )ow we are much
more of a ser!ice econom/. (n!entor/ is recore at cost in accorance with the cost
principle.
J- *here are three components to in!entor/ 4 raw materials, >nishe 2oos an wor%s4
in4pro2ress. :ll of these elements ha!e to 0e factore into an e!aluation of
in!entor/Qs !alue. :lso, /ou must R ma/ incorporate la0or costs, o!erhea (rent,
securit/, real estate cost$, etc. into the !alue of in!entor/. *he more /ou allocate to
in!entor/ the more of /our _costs_ are counte as part of an asset 4 here in!entor/.
For e3ample, coul P>5er char2e part of the research an e!elopment costs of
ma%in2 Pia2ra to in!entor/S
1- <hen we /alue our in/entory, how and when do we ta8e the 7ost of the Moods 0old "7OM0# and put
it into the e+pense column . . . , When do we make entry to inventory
a- Once we determine what the 7OM0 are, we will ma8e an entry debiting 7OM0 and crediting
In/entory , the :uestion is ! do we do t%is EVER: 685E we sell a unit or + ;ust at t%e end of
t%e period-
o 0hift into manufacturing society, there became a huge emphasis on in/entory , for car dealership,
each piece of in/entory is /ery e+pensi/e and uni:ue "with a /ehicle I? W# , therefore, it is worth it
to 8eep trac8 of all pieces of in/entory sold.
o Contrast with 7oca(7ola who ma8es soda and bottles millions of bottles of soda a day. , 1he
:uestion of how to measure in/entory is more mur8y here.
D- 1he other important element of in/entory is that computeriNation has allowed better maintenance of
in/entory. 'lmost e/eryone uses a perpetual inventory system now rather than a periodic inventory system.
In/entory is in certain respects the ultimate prepaid expense because it will be con/erted into cost of
goods sold "7OM0#, li8e insurance, etc.
a- erpetual inventory system: from a pratical business standpoint, this is better because, from a
managerial perspecti/e it is PER= important to 8now how much in/entory you ha/e. Aust about
e/eryone uses this now , before "li8e 1& years ago, this was not the case#.

eriodic !nventory system: See belo%. 8ount up the costs at the end( and figure out %hat 8osts of
-oods Sold %as.
1he following things Jin/entory spoilageK must be accounted for under 7OM0, not under the separate
e+pense of JIn/entory 0poilageK. , this goes bac8 to the JMoing 7oncern -rincipleK , damage and theft
should be part of the cost of the in/entory because they are a necessary part of doing business. 1herefore,
spoilage is a part of 7OM0. .nless, of course, there is an anomalous e/ent li8e an earth:ua8e for which
you do not ha/e insurance.
,3. 1heft , a certain amount of this goes on in e/ery business and M.01 be accounted for
wIrIt in/entory
,-. ?amaged items , must account for it as well.

Is in/entory an asset or expenseR 1he reason a company has assets is because it is in the business of selling goods
and ser/ices for B (( in/entory, when it is sold, stops becoming an asset and becomes a cost. <e don9t 8now
whether it is an asset or an e+pense, though. It9s Oust something we use in the interim.
Efficient Mar8et 1heory assuming full information all information is reflected in the market effect on
accounting! markets are not efficient, thus >I>O and )I>O can show the same info in different ways. If
efficient mar8et theory was true, people would not care about which accounting methods a company used.
1. =eneral< (n!entor/ is 2oos prouce for sale or purchase an hel for the
purpose of sale.
21
a. +P'@:11< L!at you start .it! ) L!at you add ' L!at you still !a$e
a$aila+le .!at you ?nis! .it! ' .!at you used
+. Formulas<
217 C*GSA &1 2+eginning in$entory7 ) P 2Purc!asesIproduction7 E1
2ending in$entory7
2,7 GP 2Gross Pro?ts on Sales7 ' S 2sales7 C*GS
H:.O Roommate and F(pac8 of beer that you9/e brought homeSSSbased on the formula, there were 2 beers to
begin with@ 7OM0 * 2 X F ( $
#O<= & "debit#
In/entory $ "credit# DEnding In/entory (( $ beers left o/er after we ha/e sold &E
-urchases 2 "credit#
5O1E! e/en if we engage in -erpetual In/entory, we still ha/e to engage in this formula.
2. Periodic System H Brin2 in!entor/ R 9+=, up to ate perioicall/. )either the (n!entor/
account nor the 9+=, account are %ept up to ate urin2 a perio. (nstea, the/ are
0rou2ht up to ate at the en of the perio (which in!ol!es a ph/sical in!entor/$. :lso,
rather than ma%in2 an entr/ irectl/ into asset account of in!entor/, use asset Purchase
:ccount where in!entor/ is 0ou2ht from others an Prouction :ccount where the
in!entor/ is prouce internall/. 6ain iAerence here is in the steps use in ma%in2
closin2 entries. Vistoricall/, e!er/one use this metho 0ecause otherwise it was too har
to o in!entor/ 0/ han. )o separate entr/ mae to 9+=, when sales are mae. (nstea,
/ou Eust >2ure out 9+=, at the en of the perio.
a. Proceure<
(1$ ,tep 1< Mhen /ou acquire in!entor/, ma%e a ri2ht sie cash or :R@ entr/
an a left sie entr/ to either Purchases or Prouctions (as appropriate$;
(2$ ,tep 2< Mhen /ou ma%e a sale, ma%e a left sie entr/ to cash or :R@ as
appropriate an a ri2ht sie entr/ to sales.
(H$ ,tep H< &o a ph/sical in!entor/ to >n /our enin2 in!entor/ ('($. *hen,
/ou can etermine the !alue of 9+=, from the formula< 9+=,XB( ; P 4'(.
]*o calculate the !alue of 9+=,, /ou 0e2in 0/ creitin2 in!entor/ 0/ the
amount that was ori2inall/ there (B($, e0itin2 in!entor/ 0/ the amount left
at the en ('($, an /ou en up with the in!entor/ reain2 the !alue of
9+=,. ()ote that /ou also ha!e to 5ero out purchases.$^
+. '3amples<
Perioic Purchase
PurchaseRProuction FFFF
9ash FFFF
Perioic ,ale
9ash FFFF
,ales @e!enue FFFF
:t en of perio nee to count '( to etermine 9+=,
H. Perpetual System H :ll elements of e!er/ merchanisin2 transaction are
recore when the/ occur. ,o sale an in!entor/ reuction are recore
simultaneousl/. :ccountin2 recors, without re2ar to merchanisin2 acti!ities,
are constantl/ 0ein2 upate urin2 the reportin2 perio to reCect all
merchanise4relate acti!ities. Bner this s/stem, there is no purchases account
0ecause an/ time /ou purchase in!entor/, /ou immeiatel/ e0it in!entor/ an
creit cash or :R@. :lso, when /ou sell, /ou e0it cash an creit sales and /ou
woul also e0it 9+=, an creit in!entor/ simultaneousl/.
22
a. Proceure<
(1$ Mhen 2oos are purchase or prouce (whether 0/ cash pa/ment or on
creit$, a left4sie entr/ is mae to an asset account calle (n!entor/
(amount it cost to prouce or acquire the in!entor/$ an a ri2ht4sie entr/
is mae to 9ash or :ccounts Pa/a0le for the same amount.
(2$ Mhen 2oos are sol, whether for cash or creit, ma%e a left sie entr/ to
increase the relate asset account, either cash or :P, an a ri2ht sie
entr/ to the re!enue account (,ales$.
(H$ Also, upon sale of 2oos in in!entor/, ma%e a left sie entr/ to the
e3pense account (9+=,$, an ri2ht sie entr/ to the asset account
(in!entor/$.
(D$ :t en of perio, o a ph/sical count of the in!entor/ an account for an/
iAerence (shrin%a2e$ in the num0er on paper an the num0er in realit/.
6a%e a left sie entr/ to 9+=, an a ri2ht sie entr/ to in!entor/. *hen.
close these out throu2h the PW1 account as usual.
+. '3ample
Perpetual Purchase
(n!entor/ FFFF
9ash FFFF
Perpetual ,ale
9ash (:R@$ FFFF
,ales @e! FFFF
9+=, FFFF
(n!entor/ FFFF
c. :t en of perpetual, nee to count to etermine 0rea%a2e R spoila2e R theft
=oes into 9+=,. use<
(n!entor/ shrin%a2e FFFF (amt missin2$ ]YB',*(+) (, *V(, :) 'FP'),'
:9*S`
(n!entor/ FFFF (amt missin2$
D. Bsers R Tust (n *ime<
a. */pes of users< Boein2 Perpetual, Pencil ma%er Perioic
+. (n!entor/ costs<
i- Four 9osts
(1$ interest (lost$
(2$ warehouse (space, insurance$
(H$ theft
(D$ o0solescence
ii- T(*< Tust in *ime sa!es these costs
(1$ Gou want Perpetual if /ou use T(*
(2$ &ell uses this an %eeps mar2ins own 0ecause less
warehouse space is neee
(H$ Bner this theor/, /ou onl/ 0u/ the in!entor/ when /ou %now
/ou are rea/ to sell it R when /ou ha!e essentiall/ alrea/
sol it.
c. *echnolo2/ has le to use of perpetual increasin2 use, perioic coul one
a/ cease to 0e =::P
5. Bner either s/stem, /ou still ha!e to count 0ecause /ou nee to etermine
shrin%a2e 4 theft an other ama2e losses. *wo reasons for countin2 in!entor/<
a. :sset recore.
23
b. &etermine 9+=, urin2 perio (how much in!entor/ shoul 0e con!erte into
e3pense$. 9+=, inclues stolen 2oos 0ecause 2oin2 concern assumption
ictates it#s a cost of 0ein2 in 0usiness. Me ha!e in!entor/ in orer to sell it so
if it shrin%s, that#s part of 9+=,. )atural assumption in most 0i5 that there will
0e shrin%a2e.
i. V/po< :ssume ,ales OH000. (B($ 500 4 (P$ 1500, so a!aila0le 2000 4 ('($
800 X (9+=,$ 1200. V/po< B has O1000 in 0an% at the 0e2innin2 of the
/ear. =ains O25,000 o!er course of /ear. 'n /ear with O6000. O20,000
spent.
ii. Formula 4 use whene!er /ou nee to etermine 9+=, or '( an iAerent
prices of same 2oos in in!entor/ (inCation, e2$. ('3 see H an Dth step
uner perpetual s/stem$. &1)PHE1 'C*GS
6. :etermining t!e Cost o# Goods Sold 2C*GS7 4 D :ssumptions (all accepta0le 0/
=::P uner certain circumstances$. Me on#t reall/ care if actual Cow of 2oos
matches in!entor/ metho<
1. Speci?c 1denti?cation et!od most companies o not use this metho,
e3cept for e3tremel/ unique, !alua0le items, for e3ample, airplanes, homes, or
artwor%.
a. '3. : is O100, B is O200, 9 is OH00. ,ol (tem B, 9ash e0it OH00, ,ales 9reit
OH00. 9+=, e0it O200, (n!entor/ creit O200. :mount sol minus cost X =P
(=ross Pro>t$.
b. Mhat %ins of 2oos woul use this methoS Bnique, e3pensi!e 2oos
(housin2 e!eloper, @olls @o/ce, Tewelr/$. '3pensi!e is not enou2h 0ecause
coul 0e fun2i0le.
2. Leig!ted A$erage et!od 4 Brotman sa/s KpoorL metho
a. */picall/ use for !er/ small, e3traorinaril/ fun2i0le an sta0le cost items.
Gou can use this for =::P 0ut almost no one oes.
b. For e3ample, ima2ine the 2as stationQs tan%s. *an%s are continuall/ re>lle
with 2as that came in at iAerent prices at each re>ll. +nce in the tan%, the
2as mi3es to2ether an it is not possi0le to separate the 2as at price F !s. 2as
at price G *herefore, use a wei2hte a!era2e (0ase on amounts at each
price$.
$. Cost 8lo. Assumption et!odsA
Sales
H C*GS
' G"*SS P"*81T 2AEA 3Gross argin47 this reCects the concept that, if /ou 0u/
somethin2 for O1 an sell it for O10, the amount /ou lose on the mar2in when the price
2oes own is less
=ross Proft 4 ,ellin2, =enral an :ministration (incluiin2 ta3es, etc. X JET 1JC*E

a. (18* H (ast in 8irst *ut (Boo% oA top of stac%, e2. 4 Barrel$. Best in
inCationar/ times 0ecause hi2hest cost items are sol >rst. *herefore, 1(F+
lowers the 0ottom line an therefore is 0est for ta3 purposes. Don&t have to
use same metho% for GAAP an% ta# $ur$oses unless you use C3F4 for ta#
$ur$oses in which case you must %o the same for accountin,. +nce /ou#!e
electe 1(F+, can onl/ switch awa/ 13.
24
- ()ote< (mportant in 70#s, earl/ 80#s 0ecause of hi2h inCation an corps
wantin2 to ecrease ta3es for corps who were 2ettin2 %ille 0/ inCation.
:ccountin2 policies can e!ol!e 0ecause of law/er4sponsore class action
suits$. 'arl/ 80Qs e!er/one switche to 1(F+, earl/ N0Qs, some switche 0ac%
0ecause F(F+ is a more honest metho 0ecause it sells the olest 2oos >rst.
Mith F(F+, cost of usin2 metho in this economic en!ironment is reall/ low.
- (t has 0een sai that F3F4 is intellectually honest to the balance sheet an%
C3F4 to the income statement. +n the a/ that the income statement an
0alance sheet are issue, an item of in!entor/ costs a certain amount.
3nventory that is on balance sheet is ol%est inventory an% not reKective of
what it woul% cost to re$lace it to%ay@ so F3F4 is better here- 2he income
statement is C3F4*oriente% because want to reKect ,ross $ro8t to%ay-
- 1(F+ is 0etter for ta3 purposes when prices are risin2. Mith 1(F+, /ou ha!e
lower pro>ts an therefore ha!e to pa/ less in ta3es.
+. 818* H 8irst in 8irst *ut (@otate (n!entor/ 4 Pipeline$. =i!es hi2her pro>ts
when prices are risin2 an therefore requires hi2her ta3es. *he assumption
that the >rst 2oo /ou 0u/ is the >rst 2oo /ou sell 4 4an , in turn, the last
ones /ou 0u/ are the last ones /ou sell.
i. T!is is t!e pre#erred means #or ?nancial accounting.
c. )+*' @e2arless of the 6etho Bse, the corp has one the same
0usiness an sol the same amount. But, important corollar/ is that if 1(F+
is use for *a3 purposes it 6B,* 0e use for 0usiness purposes as well.
d. 1N80#s an earl/ 1NN0#s, man/ companies switch 0ac% to F(F+ 0ecause
inCation 2oes own an companies were )+* carr/in2 as much in!entor/.
e. Brotman#s classic 6il% e3 of the iAerence 0Rw F(F+ an 1(F+ F(F+ is what
the supermar%et wants to o with the 6il% (>rst in, >rst out$ :s the
9onsumer BBG, mil%, he practices 1(F+ (last in, >rst out$ we choose the
mil% with the most istant e3piration ate.
i- MRrRt in!entor/, must ecie which metho, F(F+ or 1(F+ to use.
ii- (n certain inustries i.e. @olls @o/ce &ealer or @eal 'state (lar2e
estates$ a2ent then, /ou shoul use 6$eci8c 3%enti8cation =etho%
#. )+*',< 4 Mith lower inCation R ta3 rates companies are now switchin2
0ac% to 1(F+
,5. FIF+ is a more balance sheet accurate method( %hile >IF+ is truer to the income
statement.
,B. FIF+ ? most recent units sho% up %ith most accurate cost
,C. A company may only s%itch bet%een >IF+ and FIF+ one time for ta< purposes(
according to I#S rules. If you use >IF+ for ta< purposes( you @AS" use it for boo&
purposes and ice ersa.
,8. (6P:9* on 0alance sheet 4 consier this >rst choice amon2 accountin2
methos< '3 Pro0 D:. (6P:9* on income statement 4 statement on Gross Pro8t
on ,ales (GP ' SHC*GS$ t!is is t!e amount +y .!ic! sales e@ceed C*GS
or price c!arged less cost o# ac0uiring.
b- 'ssuming the system that we ha/e for accounting for in/entory is a good one, the only number we
ha/e to 8eep trac8 of at the end of the period is spoilage.
c- 1he reason for this is because in/entory is a maOor component of big theft and big fraud , as goods
get sold, people s8im off the top Di.e. they fa8e the sale and then screw the boo8s at the end by
ma8ing in/entory higher than it actually wasE
25
Pro+lem -a 2p. B-IB57 ma%e the followin2 calcs >rst uner F(F+, then uner 1(F+< :$ the
enin2 in!entor/; 0$ the cost of 2oos sol (9+=,$; an c$ the 2ross pro>t on sales
&:*'< B)(*, Bnit 9ost *otal 9ost
B( 100 O20 O2000
1R15 200 O21 OD200
6R15 200 O25 O5000
8R15 100 OH0 OH000
'( 200 S S
:ssume net sales were O12,000
B)(*, B( F(F+ 1(F+
100 O2,000 O2,000
P O500 O12,000 12,000
'( (200$ (5500$ (D100$
9+=, OD00 O8700 O10,100
818*A the D00 units sol (out$ were the F(@,* D00 in, which were the 100 aO20 from
B(, 200 a O21 purchase on 1R15 an 100a O25 purchase on 6R15. *he 200
remaininf are the other 100 purchase a O25 on 6R15 an the 100 purchase at OH0
on 8R15. *hus, '( X (100?O25$ ; (100?OH0$ X O5,500.
(f B( X O2000, P X O12,200 an '( X O5,500, then 9+=, X O8,700. *his can 0e
con>rme 0/ seein2 that the D00 solf (out$ were equal to (100?20$ ;(200?21$
; (100?25$ X O8700;
Gross Pro?t ' Sales C*GS ' G1,%%% H G8C%% ' G33%%
(18*A *he D00 sol (out$ were the 1:,* D00 in, which were the 100 aOH0 on 8R15,
200 aO25 on 6R15 an 100 aO21 on 1R15. *he 200 remainin2 were the other 100
purchase aO21 on 1R15 an the 100 !alue aO20 that was in B(.
*hus, '( X (100 ? 20$ ; (100 ?21$ X OD100.
(f B( X O2000 an P X O12,200, then with an '( of OD100, 9+=, was O10,100
*his can 0e con>rme 0/ seein2 that the D00 sol (out$ were (100?H0$ ;
(200?25$ ; (100?21$ X O10,100.
Gross Pro?t ' Sales C*GS ' G1,5%%%H1%51%% ' G19%%
??)+*'< @e2arless of the metho, we sol the same amount??
Inventory is HUGELY important as a measure of fraud
1e+aco E+ample! 1e+aco cheating the boo8s by where manager would fill some of the oil tan8s with water
and then add inches of oil on top of it , after this came out and the accountants got sued, accountants
started doing core tests on oil barrels "testing from the middle#.
'lso! 7raNy Eddies9 electronics approach , Eddie 8new which order the accountants would audit his stores.
3e made sure that the first stores were loaded with in/entory and then when the accountants left, the
in/entory would be immediately shifted to the ne+t group of stores. 1herefore, accountants ha/e started to
spot c%ec7 and use different serial numbers.
)ila Inc. 7opy machine business , went out and bought really good top of the line machines and released
them. 'lso manufactured $CC serial plates. 3a/e 1C machines for 1C clients in 1C cities and as8 7itiban8
to borrow against these 1CC machines, for e+ample. 1he ban8 would search the .77 for serial numbers
and ma8e sure it was O2 and )ila Inc would get the BB.
:itional question ! what are the res$ective concerns b/w buyin, a $rivate com$any
versus a $ublic com$any w/r/t F3F4 an% C3F4 an% s7immin, of the boo7s?
26
o Pri!ate 9o ma/ 0e much more concerne with ta3es an therefore, ma/ tr/ to
unerstate their in!entor/ the/ ma/ not care as much a0out what their 2ross
pro>ts loo% li%e, especiall/ if the/ are a closel/ hel compan/.
o &rotman and P!armacies Co +uyHouts lot of times, pri!ate companies, when
sol, are !alue too hi2h 0ecause the/ misrepresent their costs 0ecause the
uner4report in!entor/ (in an eAort to reuce ta3es$. *his ma%es the 0u/er 1$ pa/
more ]0ecause reportin2 less in!entor/ than there reall/ is^ an 2$ istorts the
eJcienc/ of the compan/ mana2ement ]amt of ollars earne in 2ross pro>t
relati!e to o!erall in!entor/^ 44 *herefore, as a law/er, put into the formula of
when to 0u/ ma%e a car!e out where, if the in!entor/ comes out 5Z iAerentl/
than e3pecte on either sie, /ou ma/ ela/ closin2.
7. :itional :ccountin2 (ssues for (n!entories ,'' ,BPP V:)&+B* 10R16R01, p. 2 an
()*'1 V/po
1. (o.er o# Cost or ar;et "ule 4 (n line with =::P#s principle of conser!atism (no
o!er4statements$, accounts e!ise for inventory use the 196 rule.
a. @ule requires that in!entories 0e reporte at cost, or mar%et !alue if that mar%et
!alue is lower. *his is in line with the 2oin2 concern assumption as well 0ecause
assume we are 2oin2 to use the assets as for the use we 0ou2ht them. 6ar%et
X replacement cost.
b. @B1'< Ad>ust 1n$entory $aluation to replacement Cost .!en
replacement cost is lo.er t!an original cost i# suc! impairment is
permanent.
c. Ko.e$er5 you cannot ad>ust $alue +elo. a Moor e0ual to Jet
"eali=a+le Dalue less E@pected Pro?t argin5 or a+o$e a ceiling
e0ual to Jet "eali=a+le Dalue.
Purpose of the ceilin2 to ma%e sure that co#s write own enou2h for
in!entor/ 0Rc of some 0lip in the mar%et where replacement cost is hi2her
than net !alue.
9eilin2 +)1G %ic%s into place when it ta%es more to sell the in!entor/
than to replace it.
e3. 6anual */pewriters Phenomena coul not 2et new ones to sell
for a while an ene up in a situation where it cost /ou more to sell
one than to acquire one.
Purpose of Coor %eep pple from manipulatin2 in!entor/ rates so low as,
when /ou sell it, /ou ma%e more than the E@pected Pro?t argin. (this
woul manipulate future perios to reCect future pro>ts as<
:on9t .ant to incenti$i=e a company to ta;e a 1Htime
c!arge in anticipation o# #uture e@aggerated +ene?ts.
*his is more li%el/ to occur 0ecause of a islocation in the mar%et
s/stem
'3. :lle2ation re2arin2 9(,9+ pple thou2ht that the/ were merel/
ta%in2 a VB=' char2e ri2ht now, so that, in future perios the/ woul
ha!e a lar2e " of in!entor/ on the 0oo%s so as to create the
appearance that pro>ts an eJcienc/ were ro0ust.
(ntel ha 1,000,000 Pentium H chips (PHs$ in its >nishe 2oos in!entor/ as of 1R1R01. *he/ ha cost
O22 each to ma%e an were !alue at that amount. (ntel ha t/picall/ sol each PH for OD5 an
incurre sellin2 costs of OH.00. Vowe!er, 0/ NRH0R01, the most that (ntel coul sell a PH for was own
to O26 with sellin2 costs of OD. *he cost to ma%e a new PH was ON. Mhat entr/ shoul (ntel ma%e as
of NRH0R01S
27
+ri2inal 9ost< O22; +ri2inal ,ales Price< OD5; +ri2inal ,ellin2 9osts< OH
'3pecte Pro>t 6ar2in X +ri2inal Price (D5$ +ri2inal 9ost (22$ +ri2inal ,ellin2 9osts (H$ X O20
@eplacement 9ost X ON
9urrent ,ales Price< O26; 9urrent ,ellin2 9osts X OD
)et @eali5a0le Palue ()@P$ X 9urrent Price (26$ 9urrent ,ellin2 9osts (D$ 4 O22
"uleA Ad>ust 1n$entory $aluation to replacement cost .!en replacement cost 2G97 is
lo.er t!an original cost 2G,,7 i# suc! impairment is permanentN !o.e$er5 you cannot
ad>ust $alue +elo. a Moor e0ual to J"D less e@pected pro?t margin 2G,7 or a+o$e a
ceiling e0ual to J"D 2G,,7
(n this e3ample, since @eplacement 9ost is lower than ceilin2 (O22$ an 2reater than Coor (O2$, we
use it.
(f it were a0o!e ceilin2, we# use ceilin2 (as lon2 as ceilin2 were less than ori2inal cost$.
(f it were 0elow Coor, we# use Coor.
')*@G<
(n!entor/ (mpairment '3pense< O1H,000,000 (1,000,000 ? (224N$$
(n!entor/< O1H,000,000
OA PP L!y did selling cost go up 2#rom G3 to G-7 at a time .!en cost and
replacement cost goes do.nQ
:< (ntel pa/s a su0si/ to the 0o34ma%er for runnin2 an a or sellin2 a computer with
an (ntel stic%er on it. *herefore, in times where the/ want to mar%et a PD chip, the/ will
ha!e su0siies of OH for PHs an O.50 for PDs to tr/ to 2et the ol ones oA shel!es more
quic%l/.
(ntel an 9(,9+ 2et to the point where sell more units than thou2ht the/ woul in
calculatin2 the epreciation >2ure so that, when the/ sell the same
d. +0solescence ]did .e do t!is in class ,%%1QR e!ents occur which rener
2oos o0solete. When inventory becomes obsolete@ a com$any cannot 7ee$ it
on the balance sheet- Aou cannot show it on boo7s if it is worth less than current
mar7et value 4 therefore /ou must ma%e an aEustin2 entr/.
Me are willin2 to ha!e 0alance sheet too hi2h as oppose to the income
statement too hi2h 0ecause we o not want to show hi2her pro>t mar2in than
reall/ ha!e 4 so we incorporate an/ lower mar%et !alue. ('3. important ri2ht
now 0ecause of stru22les in :sian mar%et$. 2o the e#tent that mar7et value
%eclines below cost@ an a%justin, entry is ma%e at en% $erio% to show %ecline.
6a%e a ri2ht sie entr/ to in!entor/ an a left sie entr/ to 9+=,. ()ote how
this process is similar to the process of ma%in2 aEustment for shrin%a2e$.
,9. 8urrent #eplacement .rice must be bet%een the ceiling (net realiBable alue if sold
%ith no profit) and the floor (net realiBable alue minus normal profit margin)
3%. +bsolescence Cournal !ntry,
(n!entor/ write own e3pense FFFF
(n!entor/ FFFF
28
2. Footnotes usuall/ isclose which metho use to etermine 9+=, (,peci>c
ienti>cation or cost Cow assumption li%e 1(F+, F(F+ or some a!era2e 4 thou2h
=::P oes not allow an a!era2e of 1(F+ an F(F+$.
$. 9omponent parts of >nal prouct are separatel/ coste an trac%e on the internal
0oo%s.
D. ,ee class notes from 10R1NRNN for e3ample of writin2 own in!entor/ in relation to
lower replacement costs chan2in2 the 0oo%s. *here is also information here a0out
ceilin2 an Coors for costs.
I. De$reciation: Accountin, for 8#e% assets (FA
'. @elationship to +ther 9oncepts 4 :ccountin2 for >3e assets is one of the 2reatest
a0errations 0etween accountin2 an real life. T!e systematic allocation o# t!e
cost o# ?@ed assets to e@pense. J*T intended to mirror actual $alue. For
instance, a 9o 0u/s a manufacturin2 facilit/ that it will use o!er man/ /ears cost
O1006 if too% the e3pense immeiatel/ /ou woul ha!e a O1006 e3pense in G1 an
no e3pense later. Vowe!er, this means that /ou are )+* s/stematicall/ allocatin2 the
cost of the e3pense o!er its useful lifetime. *he reason is 0ecause it is simpl/ not
practicea0le 2i!en man/ iAerent >3e assets an 2i!en the iJcult/ an su0Eecti!it/
associate with conuctin2 perioic or continuous appraisals.
1. 8i@ed Asset 4 the assets a com$any buys to use over a lon, time to ,enerate
revenues (cop/ machine, e2$. (o!er 1 /ear$. 6atchin2 Principle 2o!erns ecisions
a0out how to account for the acquisition an use of F:. F: contri0ute to earnin2
power of entit/ o!er entire useful life, so 6P sa/s cost of acquirin2 F:#s shoul 0e
allocate o!er that perio of time. somethin2 that /ou are 0u/in2 as part of that
asset (2oin2 conern presumption the reason /ou acquire an asset a car
whether or not /ou 0ou2ht the Coormats with it it is insepara0le to the car,
conceptuall/. (t is P:@* of the acquisition of the car Coor mats, raio,
unercoatin2.
&uying a +uilding e@ampleA li2htin2 >3tures as%< what is a >3ture not
onl/ is it insepara0le, 0ut, it is part of the use of the 0uilin2 for the purpose of
the 0uilin2 (e3. wall4to4wall carpetin2$ :,I< is it intene to 0e remo!e
urin2 its useful life. Furniture ma/ or ma/ not 0e intene to 0e remo!e from
the propert/.
"e#ridgeratorsA when 0u/ a house ha!e to contract in whether the
refri2erator with /ou. 9ontrast< sto!e, 2ar0a2e isposals, which are >3tures.
Vowe!er, if /ou are a 11, it is P'@G har to rent an apt without a refri2
therefore, as a 11 of a resiential apt, some of the thin2s 0ecome >3tures that
29
Exa&p!e
Bu. ) +nits at# hist"%ica! c"st );
5"%&a! Se!!ing ,%ice 2;
5"%&a! Se!!ing 0"st 2
0"st t" Bu. n"( <
0u%%ent Se!!ing ,%ice ))
5"%&a! ,%"fit =a%gin <
2; $ (); + 2) = <
0ei!ing = )> (net %ea!i?a'!e va!ue if se!! (ith n" p%"fit) ); + 2 = )>
:!""% = 8 (net %ea!i?a'!e p%"fit va!ue &inus n"%&a! p%"fit &a%gin )> $ < = 8
0u%%ent Rep!ace&ent 0"st = <
:DE
@%ite *"(n = > (hist"%ic c"st $ c"st t" 'u. n"() ); $ < = >
E53RA#
Invent"%. (%ite-*"(n expense >
Invent"%. >
were not were /ou to 0e a normal owner. the wa/ this is reconcile with the
epreciation of the 0uilin2 itself (0ecause the items ha!e iAerent useful
li!es$ is to a$ use a 0lene useful life ta0le an 0$ re4capitali5e or e3pense it
to repair.
So#t costsA attorne/#s fees, architect fees, out of poc%et insurance an/ costs
associate with acquirin2 the asset.
(e. :)G*V()= that is part of /our cost in acquirin2 the >3e asset is a part of
the >3e asset (thou2h, not countin2 thin2s that are separa0le from the >3e
asset$.
2. :epreciation 4 6ystematic allocation to e#$ense lon,*term assets / the
systematic char,e a,ainst earnin,s of the ac'uisition cost of 8#e% assets.
:llocatin2 the cost of a F: o!er its e3pecte useful life. Me o not care what
happens in real life as far as real eclinin2 !alue. ,imilar to accrual s/stem
conceptuall/ 0ecause prepai e3penses, in!entor/ an epreciation are all
emplo/e in conuct of 0usiness to 2enerate re!enue from perio to perio.
(+therwise, there are all sorts of timin2 pro0lems$. )+*' 4 lan is )'P'@
epreciate. &epreciation ena0les entities to char2e a2ainst re!enue on a re2ular
an perioic 0asis the cost of the Fi3e :ssets it uses to prouce its re!enue.
a. ,/stematic allocation of the cost of >3e assets to e3pense o!er the
anticipate economic life of the asset
(1$ )o relation to practical o0solescence
(2$ Antici$ate% economic life is how lon, you $lan to use it for the $ur$ose
for which it was obtaine%.
(H$ 1on2er R ,horter< Want lon,er %e$reciation for $ur$oses of showin,
earnin,s@ but want shorter %e$reciation for ta# $ur$oses.
(D$ For epreciation, unli%e F(F+ R 1(F+, 3)6 an% GAAP allow accelerate%
%e$reciation.
0. :ccumulate &epreciation< accumulates all of the ne2ati!e entries a2ainst an
asset o!er time
(1$ contra4asset cre%it asset JL2 on asset si%e 44 a contra account is a
temporar/ account that is tie to a particular asset account; with contra
accounts, /ou will ha!e a left sie e3pense to which the contra account
is the corresponin2 ri2ht sie account 4 an this ri2ht sie account will
0e an asset.$
(2$ :llows /ou to alwa/s see historic cost
c. Tournal 'ntr/<
&epreciation '3pense FFFF
:ccumulate &epreciation (contra account$ FFFF
6. Tu2ments @equire for &epreciation '3ercise 4 H preliminar/ Eu2ments with
si2ni>cant consequences<
1. Kistorical Cost 4 3nclu%es a%a$tation an% installation costs $lus historical cost.
Bse reasona0leness test to etermine if maintenance costs shoul 0e inclue
(as%< is this maintenance e3pense for orinar/ operation or e3tension of useful
lifeS$. *',*< whether the OO shoul 0e eeme part of the historical cost of the
>3e asset an therefore allocate to its useful life o!er time or whether it
shoul 0e treate as a one4time e3pense. 9apitali5e costs !. e3pense costs.
2. Scrap I Sal$age Dalue 4 Portion of FA that will not be use% u$ as such %urin, its
life. (@B1'< you cannot %e$reciate an asset below its salva,e value$. Boo% !alue
X cost of asset minus amount it is epreciate (at en will 0e same as scrap !alue
30
0ut can 0e measure each /ear 0/ su0tractin2 accumulate epreciation from net
cost$. 9istorical cost shoul% e#clu%e scra$ value an% inclu%e only net cost@ or
%e$reciable base . ** the historical cost to 0e allocate o!er time shoul e3clue
that amount it is an amount that is not use up urin2 the normal course of
usa2e.
$. E@pected Sse#ul (i#e 4 *his will 0e the time frame use for epreciation. Lseful
life refers to useful life for conte#t in which asset is bein, use%. 9ompare
historical e3perience of similar assets. +ften use (@ 9oe.
&epreciatin2 9osts o!er time rather than e3pensein2 them when incurre therefore
increases reporte income in the perio of actual outla/ an ecreases reporte
income in the perios to which the outla/ is char2e.
*he lower the scrap !alue place on a >3e asset, the 2reater its eprecia0le 0ase
an therefore, the 2reater the 0uren on reporte income.
*he lon2er perio of time o!er which the allocation is mae the less the impact on
reporte income will 0e in an/ 2i!en perio. *hus, the lon2er the e3pecte useful life
place on a F:, the less impact on reporte income it will ha!e in an/ 2i!en /ear, 0ut
such impact as there is will e3ten o!er a lon2er perio of time.
7. Boo%%eepin2 6echanisms for &epreciation 4 H Phases (for matchin2 principle an cost
principle$
1. Ac0uisition 4 @ecor F: at cost in left sie entr/ uner speci>c asset account (e2,
copier$. 6a%e a ri2ht sie entr/ to cash or :RP. (nclue installation, etc. in cost
0ecause those are all acquisition e3penses.
2. :uring Sse#ul (i#e 4 'ach /ear, a portion of the cost is allocate as a
epreciation e3pense. (e3. 9opier cost O11,000 to acquire; it has a D /ear useful
life an a OH000 scrap !alue; so O2000R/r strai2ht line epreciation$.
a. 6ust ma%e aEustin2 entries each /ear< *o o so, ma%e a left sie epreciation
e3pense entr/ of O2000 an a ri2ht sie entr/ to the contra account 4 a mar%er
4 here calle :ccumulate &epreciation. (&o not ma%e an entr/ to the asset
itself 0ecause we nee to report the e3pense o!er time.$ *his is eAecti!el/ a
ecrease in the !alue of the F: on the 0oo%s of the compan/. *his is a written
wa/ that ena0les us to show the histical cost of the copier on the 0alance
sheet , to2ether with its accumulate epreciation o!er time.
b. 'n G1 4 1on2 *erm :ssets 4 @ecor 0oo% !alue which is copier cost less the
accumulate epreciation X boo7 value (this is on 0alance sheet$. Gou o not
ha!e to put the amount of accumulate epreciation on 0alance sheet 0ut in
notes an the amount on >nancial statement is net, without accumulate
epreciation. ,ee p. 7H an p.7142 for e3amples.
$. A#ter Asset9s (i#e 4 Both asset account 9opier an contra account :ccumulate
&epreciation will 0e aAecte.
a. 'n GD 4 1on2 *erm :ssets 4 Boo% !alue left X scrap !alue.
b. *o account for sale for scrap !alue, ma%e left sie entries in cash for scrap
!alue an in :ccumulate &epreciation for entire epreciate amount. ()ote
that the 0alance sheet now loo%s li%e the e3ample on p. 7H$. 9onsoliate
0alance sheets onl/ report net income, not accumulate epreciation (e3cept
in notes$. *hen ma%e a ri2ht sie entr/ to the asset (9opier$ account for the
historical cost of F: to reCect that it is 2one 4 i.e. sol an therefore no lon2er
on the compan/Qs 0oo%s.
31
c. 3f a FA is sol% for more / less than boo7 value@ you must recor% ,ain on sale or
loss in the sale accounts. *his e3tra amount 2aine or lost aAects the entit/#s
0ottom line 0ut is separate 0ecause it comes from somethin2 not in the coQs
orinar/ or central 0usiness.
i. Gain 4 (ncreases in equit/ 2enerall/ from non4owner sources, which result
from peripheral or inciental transactions.
ii. (oss 4 &ecreases in equit/ from same as a0o!e.
iii. *hese 2 cate2ories are istinct from @e!enue an '3pense. Further, the/
can 0e use to reCect inciental interest recei!e or prouce, pro>t R loss
on inciental sales of in!estment, etc. or pro>t R loss from liti2ation, etc.$.
=ains can also inclue i!iens on in!estments.
i/. '3. (f copier sol for O5000 when it ha a liste 0oo% !alue of OH000 then
ma%e a left sie cash entr/, a left sie accumulate epreciation entr/, a
ri2ht sie O11,000 entr/ to the asset account (copier$, an a ri2ht sie 2ain
on sale entr/ in the amount of the 2ain 4 O2000.
/. (f instea of a 2ain, the copier sol at 0elow 0oo% !alue 4 therefore for a
_loss,_ (sol for O2000 when 0oo% !alue was OH000$ ma%e a left sie entr/
to cash in the amount of the loss (O2000$; a left sie entr/ to accumulate
epreciation for the full amount epreciate o!er the useful life of the F:
(O8000$; a left sie entr/ to the loss on sale account for the amount of the
loss (O1000$; an a ri2ht sie entr/ to the asset (9opier$ for the !alue of
the asset (O11,000$. ,
d. 6i course chan2es 4 if, in mi course, /ou isco!er that one of /our
epreciation assumptions is wron2, (e.2. machiner/ 0ecomes o0solete$, /ou
can chan2e the !alues, 0ut not historical statements (i.e. statements from
past /ears$. Bse the cost not /et epreciate an then chan2e the
information from that point onwar. Gou must isclose this action in a
footnote. Gou onl/ ma%e chan2es when /our ori2inal estimates were
si2ni>cantl/ oA 0ase 4 for e3ample, when a machine /ou thou2ht woul last
20 /ears 0ecome completel/ o0solete after 2 /ears.
e. :lwa/s %eep in min e3penses for @epairs, @eplacements. e3. tires that /ou
0u/ to put on the car /ou#!e ha for H /ears alrea/. *he car cost OH0I;
,al!a2e !alue of ON000 /ou epreciate O7I in G1; 7I in /ear2 an then
purchase tires for O1I. this e3pense nees to 0e capitali5e it is an
e3pense that is ae to the >3e asset which ma/ or ma/ not ae to the
e3pecte life in /ears of the asset. :s% 2 questions< 1$ is it part o# t!e cost
o# t!e assetTsame 0uestion as +eginningRIi.e. a ?@ed assetN 2$ oes it
ma%e the estimate useful life lon2erSR&oes it chan2e the sal!a2e !alue.
&. 6ethos of &epreciation 4 ,ee scheules in 0oo%
1. Straig!t (ine et!odA 6ost commonl/ use
&epreciation '3pense X 9ost 4 scrap !alueRuseful life. Ln%er this metho%@ an
e'ual $ortion of FA&s cost@ less scra$ value@ is allocate% to each year of its useful
life. (e.2., urin2 a 5 /ear useful life, allocate 1R5 per /ear$. *hen /ou nee to
aEust entr/. (,ee Pro0lem Fi!e.$ '3ample< :ssume a OH0,000 acquisition cost
an a O5000 sal!a2e cost o!er a 5 /ear useful life. &' X (H0,000 4 5000$ R 5 X
5000 X epreciation e3pense R /ear. 6etho< 5et cost (cost * salva,e value #
strai,ht*line $ercenta,e each $erio%- or (net cost * salva,e value / number of
years. e2 25 3 1R5 4 5000.
32
:ccumulate &epreciation 9ontra :ccount X the place where /ou put all the
ne2ati!e entries for a lar2er account a special t/pe of account that %eeps or
trac%s all of the ne2ati!e entries to the particular asset that which /ou
epreciatin2 .. F+@ 'F. ,'' ,BPP )+*', an 9ar. (t#s purpose is to 2i!e us more
information. . . For e3ample, if /ou loo% at the0alance sheet of a compan/ an it
sa/s Builin2 1006; !ersus Builin2 :ccumulate &epreciation N66 this
shows that the 0uilin2 has 2one throu2h N6Z of its useful life. 9ontra acct is
therefore a su04acct of whate!er it 2oes with it is a trac%in2 account for certain
t/pes of entries.
31. 7epreciation e<pense F (cost-scrap) G useful life
*t!er E@amples o# Contra AccountsQ (thin% of the t/pe of ne2ati!e entries
that /ou want to %eep trac% of$< :n allowance for 0a e0t for e3ample, if there
is an account for :ccounts @ecei!ea0le, then, it is a 2oo place to use a contra
account. +r, 9ompanies will use a contra account for sales 0ecause, the/ want
to %now 0oth how much is sol, an more importantl/ in this case, is how much is
returne%- *herefore contra accts s!ould +e used anytime .!en a +usiness
.ants to determine its net $alue. :n/ place where /ou care a0out a net ",
/ou ma/ want to use a contra acct to %eep trac% of the entries to the main
account.
2. Accelerated et!ods (lower earnin2s an lower asset !alues sooner than
strai2ht line. *his can 0e 2oo for ta3 purposes. 44 )B 4 we o not nee to %now
these methos as per class on 10R2HR01$
a. 6um of the Aears Di,its (6AD 4 (ncrease portion of net cost of F: to 0e
e3pense in earl/ /ears an ecrease for later /ears. (e.2., 5 /ear useful life
a the num0er for each /ear in a perio (5 ; D ; H ; 2 ; 1 X 15$ to 2et
the num0er which will 0ecome the enominator of the fraction. *o calculate
the numerator of the fraction, use the ne3t i2it in line R the opposite num0er
(therefore, /ear one 5R15, /ear 2 DR15, /ear H HR15, etc.$. ,ee p. 78.
)ote that /ou still use net cost.
3,. depreciation e<pense F (0 of years G sum) H cost ? scrap
33. "his method is *+" used to reflect the computer or car phenomena %here
depreciation ta&es place immediately ? because( that reflects actual alue. "here IS
*+ theoretical bac&ground behind this( says Brotman.
3-. Acce!e%ate* Bep%eciati"n is given t" 0"%p"%ati"ns such that the. can (%ite "ff the c"sts
"f fixe* assets n"( an* use the CC t" %einvest
35. 3he%e is n" %ea! Dustificati"n6 th"ugh6 it is %ea!!. Dust a p%actica! effect "f it 'eing t""
c"&p!icate* t" &aEe 2 sepa%ate '""Es a!!"cating assets *iffe%ent!. f"% '"th pu%p"ses9
3B. @ost corps use the straigt-line method +#( the A*I"S of .#+7A8"I+* method( and
this only %or&s %here fungible assets are sold
3C. A*I"S +F .#+7A8"I+* @!"I+7 for fungible assets -- If ."u En"(6 (hen ."u 'u. an
asset6 h"( &an. units ."u (i!! se!!6 then6 ."u can cha%ge each unit (ith an a&t "f
*ep%eciati"n $ ex9 figu%e "ut at the en* "f each pe%i"* h"( &an. units s"!* an* &u!tip!. that
'. the a&t "f *ep%eciati"n f"% each unit9
a. !<ample, a ph"t"c"p. &achine $ it sa.s h"( &an. units it can
p%"*uce "ve% its !ifeti&e an* (hen it is s"!* t" ."u6 the. a*ve%tise
that $ the%ef"%e6 afte% )= "% s" c"pies6 it &a. n"t have a usefu!
!ife an.&"%e
38. #emember( salage alue is ;ust an !S"I@A"!7 AS!FA> >IF!J ? contrast Brotmans
refridg %hich lasted 4) years s. old cell phones %hose useful life ends after seeral
months.
33
b. Declinin, Jalance =etho% 4 usuall/ Kou0leL eclinin2 0alance metho.
&epreciate to sal!a2e !alue. *his is an e!en more accelerate metho that
,G&. Vere, /ou ta%e ou0le the strai2ht line percenta2e or fraction 4 or, for
e3ample, if the fraction uner the strai2ht line metho woul 0e 1R5, then ta%e
2R5. *he 567O% 8O923 HE%E is that D0Z is applie 542 to net cost but to
remainin, boo7 value su0Eect to rule not allowin2 epreciation 0elow the
sal!a2e !alue. *herefore, when 2et to the point where the remainin2 amount
of 0oo% !alue a0o!e scrap !alue is (less than D0Z$ not suJcient to encompass
a complete epreciation, Eust su0tract the >nal amount a0o!e scrap !alue
lea!in2 the entr/ at sal!a2e !alue an then su0tract 5ero for all remainin2
/ears in useful life. @ecor openin2 0alances.
c. Lnits of Pro%uction =etho% 4 can estimate how much use /ou will 2et out of a
>3e asset an then epreciate on the 0asis of that estimate. *his woul, for
e3ample, 0ase the epreciation on the preicte amount of prouct that a
machine woul ma%e. *hen i!ie the cost of the asset 0/ the num0er of
proucts mae so that urin2 each perio, /ou woul epreciate for the
num0er of proucts /ou woul ma%e urin2 that perio.
%. *hese methos seem ar0itrar/ so wh/ o we not Eust ta%e the real eclinin2
!alueS Because we nee to ta%e into account the use to which we are puttin2 the
asset (useful life$. Mhen we tal% a0out mar%et !alue, we are tal%in2 a0out
liquiation !alue, which we o not care a0out if we are not 2oin2 to sell the asset.
*hese co#s are not in the 2oin2 concern of sellin2 these assets 4 that is wh/ the/
are classi>e as >3e assets.
&. Tusti>cation for ,G& an &&B<
a. 6imics real epreciation 4 equipment is worth more at the 0e2innin2.
b. 'ase of computation
c. :ccelerates ta3 euctions
d. 9ompromise in which one of the methos accepte 0/ =::P is frienl/ wRrRt
ta3.
F. )ow, almost no one uses ,G& an &&B 0ecause new s/stem incorporate into ta3
coe scheule s/stem, :ccelerate 9ost @eco!er/ ,/stem. 44 that is wh/ we o
not ha!e to %now them 4 an the/ are not =::P.
E. 9onsequences of 9on!entions 4 6ana2ement of entit/ chooses metho. &ri!en 0/
impact on reporte earnin2s.
1. 8inancial "eporting $. Ta@ "eporting 4 Bnli%e 9+=,, mana2ement can use 2
iAerent methos (espite consistenc/ principle$ for ta3 an >nancial reportin2.
*herefore, companies usuall/ use strai2ht4line metho for >nancial reports an an
accelerate metho for ta3 purposes (so as to lower lia0ilit/ (lower earnin2s$$.
2. 9onsistenc/ Principle 4 entit/ shoul avoi% chan,in, the metho% of %e$reciation
for a $articular asset from $erio% to $erio%. =::P prohi0its chan2e from strai2ht
line to accelerate for particular asset (thou2h not !ice !ersa$. Vowe!er, not all
assets must use same metho%.
$. &isclosure 4 Footnote shoul state the metho, ran2e of useful li!es for asset
cate2ories, metho of calculatin2 epreciation 0ase 4 e3pensin2 !. capitali5in2
costs$, metho of treatin2 F:s upon isposition, etc.
34
>. :epletion and Amorti=ation H
1. &epreciation 4 technicall/ applies to F: ha!in2 ph/sical e3istence (machiner/, etc$
an not those that are literall/ consume o!er their li!es (oil, etc$.
2. +ther %ins of assets 4
a. :epletion 4 epreciation equi!alent for assets literall/ consume (mineral,
etc$. 9ost of assets allocate 0ase on units$.
b. Amorti=ation 4 intan2i0le asset equi!alent. (&eals with such thin2s as patents
an traemar%s$. 9arr/in2 !alue reuce irectl/ 0/ amount of amorti5ation
e3pense without usin2 a contra account as accumulate amorti5ation. *here is
a ma3imum of D0 /ears on 2oowill.
VGP+*V'*(9:1 with Vanout on 10R2HR01 (epreciation$ ()*'1 an Flashchips.
)+*' 1 0ecause at some point in Gear 2000, we are not char2in2 epreciation an/ lon2er
(0ecause we ha!e sol more 2oos than we e3pecte$ therefore, we ha!e 2reater cash Cow.
But, e!en thou2h we are sellin2 more proucts than the /ear 0efore, we ha!e a lower =ross
pro>t percenta2e 0ecause of the hi2h cost of 2oos sol.
6ost companies choose alternati!e : so that the/ ma/ reach the sweet spot i.e. 0/
estimatin2 their " of units sol, if the/ unerestimate that amount, the/ will, at some point
when that amount has 0een e3ceee, reach the sweet spot 44 44 this wa/, the 2ross pro>ts
will not fall oA si2ni>cantl/ in later /ears. T!ere#ore5 al.ays as; .!at t!e component
o# t!e gross pro?t percentage5 !o. did it come a+out5 and5 is it a result o# not
#ully depreciating all o# t!e e@penses.
ASE &"*TAJ *"E A&*ST TK1S C"AP.
10RH0 9hapter 6 (:R@, (ntan2i0les an 1oss 9ontin2encies$
I3- 4ther Asset an% Ciability 3ssues *his is an important topic.
'. "ecei$a+les 4 Accounts "ecei$a+le (:R@$ 4 Amounts %ue from customers in
res$ect of sales on cre%it. :ll recei!a0les are consi%ere% current assets. '3ample< F
usin2 a creit car is not an :R@ to the 0oo%store, 0ut is an :R@ to the 0an% issuin2
the creit car. *herefore, the 0an% woul ma%e a left sie entr/ to 0an% recei!a0le
in the amount of the transaction (O200$ an a ri2ht sie entr/ of the same amount to
cash. 6ore t/pical with re2ar to 0usinesses whose clients are other 0usinesses. For
e3ample, recei!a0les< ma%e a left sie entr/ of O1000 an a ri2ht sie entr/ to equit/
also for O1000.
Bses a lot of the same lo2ic as 1oss 9ontin2encies.
Basic Principle of :cct X 6atchin2 Principle X match e3penses to the perios in which
the/ relate
Ba e0t (Eust li%e spoila2e in in!entor/$ is a cost of oin2 0usiness.
:t the en of each perio, we must ma%e a etermination as to what out accounts
are. For instance, if we ha!e e3tene a lot of creit in 2001 an it su0sequentl/
2oes 0a in 2002; we )''& to ma%e an aEustin2 entr/ to our 0oo%.
Mhen is an appropriate time to not ma%e an aEument an instea Eust write4oA
the 0a e0t when it 0ecomes ue<
o (mmaterialit/ (i.e. the e minimus e3ception$
o Mhen /ou cannot ma%e a reasona0le estimate of the write4oA amount
For e3, /ou ha!e a lot of :R@ in a )'M 0usiness era. For e3ample<
0e2innin2 1NNN, )ortel, 9(,9+, 1ucent who ha sol 6:,,(P' amts
of 2oos to ot.coms an telecom companies an no0o/ ha an/
iea how much to write oA for the recei!a0les. (n the >rst /ear,
35
when the 9o#s. were pa/in2 for e!er/thin2, the/ were pa/in2 oA the
purchases 0ase on (P+#s an in anticipation of G2I there was a nee
for this. (nstea, estimates were not 0ase on an/ particular
historical si2ni>cance an then when the 0a times came, there were
VB=' char2e4oAs.
1. V/po< G sells O100,000 worth of plum0in2 >3tures on 2R10 on terms of net H0
a/s, with a special pro!ision that if pa/ment is recei!e within 10 a/s, he woul
recei!e a 2Z iscount. Vow o /ou account for thisS :ssume this is the inustr/
stanar. :lso assume that NDZ of customers pa/ within 10 a/s.
a. Jet et!odA ma%e a left sie entr/ to :R@ for ON8,000 an a ri2ht sie entr/
to sales for ON8,000 +@
b. Gross et!odA ma%e a left sie entr/ of O2000 to the account of iscountin2
e3pense, a ON8,000 left sie entr/ to :R@. an ari2ht sie entr/ of O100,000 to
sales. (n this h/po, the net metho woul 0e prefera0le. *his metho is
2enerall/ use either after one has ta%en the iscount or when there is
uncertaint/ a0out whether the iscount will 0e 2i!en.
c. Vow man/ ta%e iscountS :ssumin2 that most 0u/ers will ta%e the iscount,
then the issue is what is recor%e% as sales- 3f a com$any normally has sales at
a %iscount@ then recor% as %iscount. (f onl/ half of oneQs customers use
iscount (uncertaint/$, use left entr/ O100,000 to :R@ an ri2ht sie entr/ of
O100,000 to ,ales. *hen if the customer oes pa/ within the 10 a/s to qualif/
for the iscount, then ma%e a ri2ht sie entr/ to cash for ON8,000, a ri2ht sie
entr/ to iscount e3pense for O2000, an a left sie entr/ of O100,000 to :R@ 4
2ross metho.
2. 9har2e oAs 4 uncollectible accounts that are not lon,er assets but re$resent
e#$enses or the cost of %oin, business 0/ e3tenin2 creit. 'ntit/ is ta%in2
enou2h ris%s if a!era2e e3pense here is at inustr/ a!era2e. =atchin, $rinci$le
sa/s that char,e*ofs must be allocate% as e#$enses to the $erio% in which
relate% sale on cre%it occurre%, therefore, compan/Qs must ma%e an estimate at
the en of each perio as to what portion of :R@ 2enerate that perio will
e!entuall/ 0e eeme char2e4oAs (uncollecti0le$. (f /ou unerestimate to an/
su0stantial e2ree an the amount set out in the allowance has 0een use up,
/ou shoul e0it 0a e0t e3penses for the aitional amount o!er the allowance.
(n ma%in2 these estimates, companies rel/ on past e3perience an current
economic conitions. Bner the principle of conser!atism, companies shoul err
on the sie of o!erestimate an not unerestimatin2.
(n orer to o this, the compan/ must ma%e an aEustin2 entr/ to reCect this
estimate<
a. 9osts of &oin2 Business :llowance methos of :llocatin2 9har2e oAs <
i. percenta2e of sales (0ase on historical sales$ 4 6atchin2 Principle
ii. percenta2e of creit sales (0ase on histor/$ 4 6atchin2 Principle
iii. percenta2e of recei!a0les
'3ample<
,tart with 100,000 :R@<
:R@ 100,000
,ales 100,000
44 9ollect O60,000 in cash on accounts ue<
9ash 60,000
:R@ 60,000
36
44 :llow 2Z of :R@ to 0e consiere uncollecti0le<
Ba &e0t '3pense 800
:llowance for &ou0tful :ccounts 800
44 )e3t /ear, sell O150,000 on account<
:R@ 150,000
,ales @e!enue 150,000
44 *a%e in cash for O160,000
9ash 160,000
:R@ 160,000
44 )ow, write oA O600 in uncollecti0le e0ts in :R@<
:llowance for Bn4collecta0le :ccounts 600
:R@ 600
44 )ow ma%e an entr/ for the 2Z estimate amount of uncollecti0le
mone/ owe. Vere, this is an allowance of O588. Because we alrea/
ha an allowance 0alance of O200 remainin2, we onl/ nee to eal with
the OH88 not /et co!ere.
Ba &e0t '3pense H88
:llowance for &ou0tful :ccounts H88
:ctual write oA to account is a e0it to contra account an a creit to the
corresponin2 asset. *herefore, this reall/ oes not chan2e the 0alance sheet
at all an there is no chan2e to net income.
(f /ou unerestimate to an/ su0stantial e2ree an allowance is 2one, /ou
shoul e0it 0a e0t e3pense for the aitional amount o!er the allowance.
:n estimate must 0e _ri2ht when mae,_ not _ri2ht._
)ote that on the 0alance sheet, /ou ta%e AI" H allo.ance ' net AI".
Vere :R@ 2N,D00
1ess allowance 588
)et :R@ O 28,812
b. :R@ a2in2 (most commonl/ use an 0ase upon how ol the accounts are$.
:s the accounts 0ecome more a2e, the percenta2e of the accounts that will
2o 0a is hi2her. Mhen Businesses as% 0an%s for a loan 0ase on their :R@
the 0an% will as% for an a2in2 sheet an then 0ase how much the/ len as a
percenta2e of the 0usiness# a2e accounts.
37
'3. 9reit ,ales< O100I
:R@ 4 OD0%
04H0 &:G, 44 O25I
H1460 &:G, 44 O10I
614N0 a/s44 OHI
N1 an a0o!e 44 O2I
?2.5Z of total accounts recei!a0le X O1000 we o not %now which account is 2oin2 to 2o
0a, 0ut, ha!e crei0le e!ience 0ase on estimations that O1000 will 2o 0a.
Ba &e0t '3pense (&e0it$ O1000
:llowance for &ou0tful :ccts (9reit$ O1000
:llowance for &ou0tful :ccts O600
:R@ O600
Estimating t!e amount #or .riteHoUs is a place where 0usinesses can reall/ hie
thin2s. (n earl/ 1NN0#s 0an%s were actuall/ a0le to 0ear the 0runt of economic own4
turn 0ecause of the write4oAs (estimatin2 how much of their :R@ woul 0e 0a e0t.$
'nron e3ample now an OBillions of write4oAs. :lle2el/, 'nron performe a Pon5i
,cheme. @elate part/ situations where entities were create an the/ 0oo%e a
recei!ea0le. 9ompan/ : woul 0u/ somethin2 in Fair 6ar%et to 9ompan/ : for O100
an 'nron woul re4sell the item for 2reater an 2reater prices to su0siiaries
controlle 0/ them[ (n turn, their :R@ loo%e increi0l/ 2oo.
Vow oes an auitor come in an >n out if the accounts are 2oo i.e. whether the/
are mae upS :< @un the :R@ list throu2h a computer an sens letters to
other companies to etermine whether the amount owe is accurate[(f a 2enuine
thir part/ is noti>e that their :RP to 'nron is o!erstate, then the/ will /ell.
'3. +n 12RN7, :B9 (nc. has an :R@ 0alance of O70,000.
+n 12RH1, :R@ 0rea%s own as follows accorin2 to how lon2 O is
outstanin2<
04H0 a/s O50,000
H1460 O10,000
614N0 O5,000
N14120 OH,000
121; a/s O2,000
:llowance for 0a e0t X 100
38
*his is a contra account which
accumulates the ne2ati!es from :R@
In actuality, the amt of write(offs for 2CC2 was BFCC "we o/erestimated#
39. 8ompanies %ill ta&e different percentages for each of these age-based categories
because there is a greater chance that a ne%er debt %ill ultimately come in than that
an older one %ill. For e<ample( a company might ta&e only 9K of the amount
outstanding from the 5-L5 days period (3M55)( 4K of that from the L9-)5 category and
so on a total of 3L955.
-%. Ad;usting !ntry at end period, ma&e a left side entry to the e<pense account called
An-collectable G 7oubtful Accounts !<pense. ("hat e<pense %ill be closed out into the
. N > Account at the end of the period %ith all other e<penses.) For the right side
entry( %e could ;ust reduce AG# by the amount of the estimated charge-off( ho%eer(
then the sum of the indiidual accounts %ould not e2ual the total amount of the AG#
reported. "herefore( for the right side entry( %e use a separate account( called
Allo%ance for 7oubtful Accounts. ("his is a contra account that matches up %ith AG#.)
-1. !<ample,
6te$ .< :llowance for &ou0tful :ccount X contra account. 6a%e a left
sie entr/ into allowance for ou0tful accounts for H,100 an a ri2ht
sie entr/ to 0a e0t (or uncollecti0le accounts$ e3pense for H,100. ((f
/ou use the percenta2e of creit sales, /ou woul not use allowance
account$. 4n balance sheet@ A/) * Allowance D 5et A/) (O66,800$.
6te$ << Mhen account 2oes 0a, ma%e a ri2ht sie entr/ to :R@ in the
amount of O2700 (creit$ an a left sie entr/ to the allowance
account for O2700 (e0it$. *his write oA reallocates 0etween primar/
an contra accounts thou2h the net eAect on 0alance sheet is
none3istent.
c. &irect write oA metho< rarel/ use; one when /ou %now that an account will
not 0e pai oA; then /ou write it oA. )ote, this is not GAAP. For e3ample,
ma%e a left sie entr/ to 0a e0t e3pense for O100,000 an a ri2ht sie entr/
to :R@ for O100,000. *his metho onl/ wor%s R is use if the 0usiness is !er/
small R the mone/ in :R@ is not su0stantial or if this is not a real 0usiness (:R@
few an 0i2$ can use this metho.
d. 6ethos tell us when to recor the e3pense<
i. Mhen it is pro0a0le an amount is fairl/ estimata0le
ii. 6ost 0usiness use allowance metho which requires an estimate
iii. &irect write oA is use when /ou cannot estimate or amounts are not
material
6. Financial :ssets 4 (n!estments in other 0usinesses.
1. ar;eta+le Securities (p. 8N$ (current on 0alance sheet$ 4 )+*' 4 F+11+M
91:,,, )+* B++I V'@' 44 the 0oo% is wron2 here an it &+', )+* F+11+M
=::P[. 1iqui :ssets in!este in when compan/ has more cash than necessar/
for current an near term 0usiness purposes. Vistoricall/ ha to 0e reporte at
lower cost or mar%et 0ut pro0lematic 0ecause of short term in!estments. For
e3ample, companies ha!e mar%eta0le securities for iAerent reasons (,ee H
cate2ories 0elow$. 9ompanies 2enerall/ fa!or thin2s li%e income /ielin2
39
securities, such as B, 0ons or other 0ons an stoc%s. 1iqui assets li%e this
appear uner 6ar%eta0le ,ecurities in 9urrent :ssets section of 0alance sheet.
J*TEA See Class Kandout 11IBI%1
a. 9lassi>cation of ,ecurities< =ar7etable 6ecurities X securities that a compan/
plans to hol for less than one /ear from the 0alance sheet ate. *hese are
securities that not onl/ can the compan/ reail/ con!ert into cash, 0ut the
compan/ intens to o so. (f the compan/ plans to hol these securities for a
lon2er term, then the/ are calle 3nvestment in 6ecurities which are liste as a
lon2 term asset on the 0alance sheet. For the purposes of the pu0lishe
>nancial statements, all 6, are 2roupe to2ether into a sin2le line on 0alance
sheet as current assets. *hese securities are liste 0etween current assets an
other assets li%e propert/, the plant, etc. *he accountin2 con!ention here
epens on the t/pe of securit/ (e0t R equit/$ an the >rmQs purpose in
holin2 it.
b. Daluation o# Securities at Ac0uisition 4 ,ecurities are initiall/ recore at
cost, incluin2 purchase price, commission, ta3es, etc.
4 '3ample< ma%e a left sie entr/ to mar%eta0le securities (6,$ for O10,H00
an a ri2ht sie entr/ to cash for 10,H00.
4 &i!iens 0ecome re!enue when the/ are eclare.
4 (nterest on 0ons 0ecomes re!enue when earne.
4 ,o, if /ou ha!e a i!ien of O250 an interest of OH00, ma%e a left sie entr/
in &i!ien an (nterest @ecei!a0le account an ri2ht sie entries in each of
&i!ien @e!enue an (nterest re!enue accounts.
c. Daluation Su+se0uent to Ac0uisition 4 &eparts from strict acquisition cost
accountin2. H =::P require cate2ories of securities< 0ons (in!estments$
hel until maturit/; securities a!aila0le for sale; an mar%eta0le securities. :t
the en of each /ear, the compan/ will mar% its securities to mar%et !alue 4
calle _mar%in2 to mar%et._ (*his is to mar% the !alue on the 0oo%s either up
or own, epenin2 on what happene to the !alue.$ (f it is a train2 securit/,
the unreali5e 2ain R loss is an income statement item which aAects /our
current /earQs earnin2s. (f 2ain R loss if for a securit/ a!aila0le for sale, then
this is an ownerQs equit/ account an therefore it aAects the 0alance sheet an
not the income statement. (*his istinction ma%es sense with the 2oin2
concern assumption.$
4 '3ample 4 if a compan/ 0u/s a stoc% for ON5 R share an then its !alue 2oes
up to O110, then /ou woul eal with the 2ain iAerentl/ if /ou 0ou2ht the
stoc% for a 0usiness purpose (2oes into an ownerQs equit/ account for
unreali5e holin2 2ain an not onl/ the income statement$ than if /ou 0ou2ht
the stoc% for train2 purposes (then it 2oes on the income statement$. 44 )ote
that to ha!e a 0usiness purpose, the asset oes not 2o on the current /earQs
income statement 0ecause it is not income if it is part of a 2oin2 concern for
the 0usiness.
40
i. )+* 6,< Debt securities for which a com$any has the $ositive intent an%
ability to ho/d unti/ they &ature (e3. Bons, &e0entures, that 0u/ for the
purpose of holin2 to maturit/$(e3ample 4 9one 0u/s B, 2o!ernment
securities whose perioic pa/ments an maturation !alue e3actl/ equal its
own outstanin2 0ons.$ (e3. enter into a ,ettlement :2reement with a
corp that /ou ha!e a 9ontractual &ispute with the other part/ ma/ insist
that /ou 0u/ a 0on an assi2n it to them collaterall/. @ecore at
amorti5e cost an then if there is a iscount or premium it has to 0e
recore at the iscountRpremium o!er the le!el /iel (see, a0o!e$ Vere,
e0t securities appear on the 0alance sheet at amortiFe% ac'uisition cost.
],tart with what /ou pai for (; premium or iscount if /ou pai more
than face !alue (premium$ or less (iscount$.$ *hen amortiFe the $remium
(e#$ense / %iscount (income over the life of the security. ()ote that a
premium reuces the income interest, while a iscount raises income
interest.$^ =ust amortiFe %iference between ac'uisition cost an% maturity
value over life as an a%justment to interest revenue.
4 '3ample of entries for a O1000 0on with an interest rate of 15Z o!er 10
/ears<
Bon 1000
Premium 100
9ash 1100
9ash (interest$ 1D0
Premium (amorti5ation e3pense$ 10
(nterest @e!enue 150
'nin2 0oo% !alue after >rst /ear X 10N0
ii. 6,< &e0t W equit/ securities hel as acti(e tradin" securities actively
tra%e% for short term $ro8t $otential. ('3. : 6utual Fun$ *hese securities
are hel for the purpose of sellin2 (not for a 0usiness purpose$. *his
cate2or/ co!ers every security that is not a %ebt security or security
available for sale so purpose matters. (nclue 6, in current asset section
of 0alance sheet. *hese 6, are reporte at mar7et value 0ecause that
pro!ies the most o0Eecti!e !alue measure an the 0est information.
3ncome 6tatement recor%s loss (%ebit an% ,ain (cre%it for %ecreases /
increases in mar7et value in an account calle% LnrealiFe% 9ol%in, Coss or
LnrealiFe% 9ol%in, Gain on Ialuation of 2ra%in, 6ecurities- ,o therefore, if
2oes up in !alue 2et 2ain in re!enue an if 2oes own in !alue, ta%e a
re!enue loss. ()ote that these are separate account from re!enues an
e3penses$.
4 Process< ma%e a left entr/ into 6, at mar%et price, a ri2ht sie entr/ into
cash;
ma%e an aEuste mar%et !alue entr/ at the en of the perio throu2h a left
sie 6,
entr/ (increase amount$ an a ri2ht sie entr/ to Bnreali5e Volin2 =ain.
4 'ntries<
*rain2 securities 1,000,000
41
I/S acc"unt
c!"ses "ut at en*
"f pe%i"* p"ste*
t" %evenues9
B"esnFt ca%%. "ve%
t" next pe%i"*
9ash 1,000,000
*rain2 securities 200,000
Bnreali5e Volin2 =ain
+n *rain2 ,ecurities 200,000
9ash 1,H00,000
*rain2 securities 1,200,000
=ain on sale 100,000
9ash 1,H00,000
Bnreali5e Volin2 =ain 200,000
,ecurities a!aila0le for sale 1,200,000
=ain on ,ale H00,000
'Aect (R,
iii. 6,< &e0t W 'quit/ hel as securities a(ai/ab/e !or sa/e (,:,$ (:cti!e
mar%ets trae$. (e3. 9(,9+ ma%es in!estments in 9ompan/#s whose
proucts aAect them irectl/Uthis permits 9(,9+ to sit on man/ 0oars, to
0e pri!/ to info an to potentiall/ inCuence a compan/ not to 2o pu0lic
e3. ,erin who 9(,9+ purchase after ownin2 10Z$ Lsually ac'uire% for
o$eratin, $ur$ose@ business $ur$oses@ with no restrictions on sellin, them.
*hese are recore at mar7et value in the 6, section of the 0alance sheet.
Bnreali5e 2ain R loss is not inclue in net income, 0ut 2oes onl/ in
separate owners equit/ account.
4 ,o this entr/ 2oes irectl/ into the +wnerQs 'quit/ :ccount an oes not
eAect the income statement until it is actuall/ sol.
4 'ntries
,ecurities a!aila0le for sale 1,000,000
9ash 1,000,000
,ecurities a!aila0le for sale 200,000
Bnreali5e holin2 2ain
on securities a!aila0le for sale 200,000
]'3ample< ma%e a left sie entr/ to Bnreali5e holin2 2ain on ,:, O10 an
a left sie entr/ to cash of O115. 6a%e a ri2ht sie entr/ to mar%eta0le
securities for O115 an a ri2ht sie entr/ to 2ain on sale of ,:, O10.^ Mhen
/ou actuall/ sell it, an/ 2ain or loss 2oes on the income statement. ,ee
hanout. Me ela/ reportin2 2ain R loss until sol 0ecause of the !olatilit/
of the mar%et. 9ompanies ha!e an (ncenti!e to ha!e securities treate in
this manner 0ecause companies o )+* li%e not to 0e a0le to control their
)'* ()9+6'[therefore, 0ecause this t/pe of securit/ oes )+* eAect the
income statement until it is sol, it is more preicta0le :n, when
companies 0u/ train2 securities, the shareholers ma/ complain that the/
0ou2ht shares of a software co for e3ample, an i not want such a mi3e
portfolio.
i/. &isclosures are require each perio
2. (ong Term 1n$estments< there are iAerent methos for accountin2 for
in!estments when the/ amount to more than 20Z of a compan/Qs outstanin2
shares.
42
@%iting up asset f"% change in its
va!ue 'ase* "n !ast *a. in pe%i"*
this is an O(ne%Fs Equit. Acct that
accu&u!ates the inc%ease "%
*ec%ease in the Secu%it.Git is si&i!a%
t" a Hc"nt%aI acc"unt9
a. (n!estment 6etho< Bse when acquisition is less than 20Z of outstanin2
!otin2 stoc%.
(1$ account at acquisition cost
(2$ i!ien<
9ash FFFF
&i!ien (ncome FFFF
b. 'quit/ 6etho of :ccountin2 4 20 4 50Z of outstanin2 !otin2 stoc%. *he other
compan/ is calle the in!estee an the in!estin2 entit/ is the in!estor. *he
in!estor reports the initial in!estment in the in!estee at cost. *he in!estment
is then a%juste% each year to reKect chan,es in the owner+s e'uity of the
investee. )ecei$ts of cash %ivi%en%s are treate% as convertin, a $art of the
investment from an interest in the investee+s owner+s e'uity to cash. (,uch
in!estments are not su0Eect to the lower cost or mar%et theor/. Vowe!er, if
the mar%et !alue of the in!estment falls 0elow the carr/in2 !alue of the
in!estment, then this must 0e isclose in the footnote.$
(1$ :llocate to 0alance sheet an amount equal to portion of income of the
compan/
c. 9onsoliation 6etho of :ccountin2 4 50Z or more. ParentRsu0siiar/
arran2ement. ,eparate >nancial statement an then consoliate to show
a22re2ate conition, possi0le te3tual iscussion.
d. '3ample<
$. *t!er 8inancial 1nstruments 4 reuce ris%s
'3ample< &eri!ati!es 4 !alue of >nancial instrument eri!e from some other
0enchmar% such as an interest rate swap. . ,o far not require to 0e reporte as
an asset R a lia0ilit/.

7. 1ntangi+le Assets 4 reporte at cost (i.e. the amount at which the 9ompan/ pai for
them$ to2ether on 0alance sheet. For e3ample, /ou 0u/ a patent, that how much the
cost of the asset is, for e3ample, )(I' 0ou2ht the swoosh for onl/ O70 an the/ %eep
it on their 0oo%s at that amount. (t 0ecomes more complicate when 9os e!elop
their own (P stuA. @esearch an &e!elopment costs, for e3ample, can +)1G 0e
capitali5e an put onto the cost when the ru2 0ecomes an ienti>a0le prouct.
+therwise, it must 0e chal%e up to =')'@:1 '3pense. For e3ample P>5er spent up
to OH006 to e!elop a cure for male impotenc/, 0ut, i not ha!e an ineti>a0le
prouct until the/ ha alrea/ spent O2606. *herefore, the onl/ e3pense that can 0e
amorti5e is the OD0 spent once Pia2ara 0ecame an ienti>a0le prouct. 9an onl/
char2e4oARamorti5e an asset o!er one of the shortest perio of time<
1. the speci>c le2al life of the entit/ (e3. a license$
43
Legen*# c"&pan. has 2 &i!!i"n in assets6 )9; &i!!i"n in !ia'i!ities 9; &i!!i"n in OE9 A"u "(n JK "f
the c"
A = L + OE
2 &i! )9; &i! 9; &i!
97 &i! = "u% inte%est (JK f 9; &i!!i"n)
92 &i! = &in"%it. inte%est in su'si*ia%.
B/S
Sh"( a!! 2 &i!!i"n "n ."u% assets
Sh"( )9; "n !ia'i!ities
OE sh"( negative 92 f"% &in"%it. inte%est in
su'
I/S
Sh"( a!! %evenue an* expenses
L &i!!i"n in %evenue
( 7 &i!!i"n in expenses
) &i!!i"n in t"ta! net inc"&e
B+3 negative L6 in "u% I/S f"% &in"%it.
inte%est in inc"&e f%"& su'si*ia%.
2. the reasona0l/ e3pecte economic life (ma3 is D0 /ears$
,ee VGP+ in hanout this is a multiple choice e3am st/le question. Pepsi 0ou2ht Yua%er
+ats speci>call/ for the asset of =atorae.
"2 For Pepsi, 0ecause it woul#!e ha to 0e full/ amorti5e o!er D0 /ears, the amount on
the 0alance sheet, currentl/ woul 0e O0. For =atorae, the amount Kproperl/ allocateL
was O2 Billion.
@emem0er, the limitation of accountin2 is that the time !alue of O is i2nore 0/ accountin2.
1imitation of 9ost :ssumption is that /ou o not write4up !alue of assets as the/ increase
on the open mar%et. For e3ample were )i%e to 0u/ @ee0o%, it woul not 0e allowe to
recor :)G*V()= on its 0oo%s for the increase mar%et !alue of the )i%e ,woosh, 0ut,
woul nonetheless, ha!e to recor all its costs to purchase @ee0o%. For Pharma 9os, their
proucts are almost alwa/s uner!alue 0ecause cannot e3pense the full amt that spent on
@ an &; an, once it actuall/ 0ecomes a useful prouct, the !alue soars.
*hese inclue intellectual propert/, etc. *his is essentiall/ ientical to >3e assets.
*hese are amorti5e (which is the same as epreciation$ which is the systematic
char,in, to e#$ense of the ac'uisition cost of intan,ible assets. +nl/ irectl/
attri0uta0le acquisition costs can 2o on the 0alance sheet. 9ost of research an
e!elopment are current char2es to earnin2s an cannot 0e allocate to speci>c assets.
Gou onl/ amorti5e the !alue when /ou acquire the intan2i0le asset. (f /ou create it, /ou
cannot claim it o!er time 0ecause research an e!elopment are current char2es to
earnin2s.
H. Aou %o not list / show a 2= on a 8nancial statement as an asset@ but you woul%
show it as $art of $urchase $rice if you bou,ht it.
a. *herefore, thin% a0out the >nancial statements of 9o%e an Pepsi< no !alue for
*6 of 9o%e 0ut millions for Pepsi *6 0ecause 9o%e has ne!er 0een sol an
Pepsi has.
0. 2his value must be amortiFe% 0ecause it is part of 2eneratin2 re!enues for the
0usiness as a 2oin2 concern.
4 Patents are amorti5e o!er their life e3pectanc/
4 *6#s R b#s are cappe at a ma3imum of D0 /ears
c. 'ntries<
(&e0it$ amorti5ation e3pense FFFF
(9reit$ intan2i0le asset FFFF
D. Good.ill 4 iAerence 0etween purchase price pai an the fair mar%et !alue of
the net assets acquire in a 0usiness com0ination, usin2 the $urchase metho% of
accountin2. (0oo% !alue, 2oin2 concern !alue$ &ue to the 6onetar/ *ransaction
principle, 2oo will is not recore uner =::P.
a. Purc!ase et!od 4 3 corp acquire / corp. *he amount 0/ which the
purchase prices e3cees 0oo% !alue is the !alue of 2oo will. (Vere, /ou ma/
o those thin2s which are not orinaril/ allowe uner =::P 0ecause it is no
lon2er su0Eect to the 2oin2 concern assumption; therefore, e!aluate 2oowill
at fair mar%et !alue 4 an amorti5e it for no more than D0 /ears.$
b. 3f $urchase $rice is less than net assets@ %ebit owner+s e'uity.
c. Kistorical Cost Principle 4 &e>cienc/ of intan2i0le asset is that it usuall/ has
a hi2her !alue. *his woul 0e at proper !alue onl/ if sol. =oowill ma/ onl/
0e recore BG (*,'1F (separate from cost reportin2 of patent, for e3ample$ if
44
the entit/ is sol. =oo will must 0e amorti5e 4 therefore it is similar to
epreciation. :lwa/s use strai2ht line metho (D0/r limit on 2oowill; patent
4onl/ life of patent; cop/ri2ht SS$. )ow, 2oo will is ta3 eucti0le.
i. '3ample< *6 is worth O100,000 an it has a life of 20 /ears. *o account for
this, ma%e a left sie entr/ to *raemar% for O100,000 an a ri2ht sie entr/
to cash for O100,000. *hen, each /ear, ma%e a left sie entr/ to
:morti5ation '3pense for O5000 an a ri2ht sie entr/ to :ccumulate
:morti5ation (a contra account$ for O5000.
ii. '3ample of accountin2 for 2oowill without a contra account< 6a%e a left
sie entr/ to amorti5ation e3pense for O5000 an a ri2ht sie entr/ for
2oowill for O5000.
?. (eases and *t!er (ong Term *+ligations
1. 1eases 4 Bse of 2oos R propert/ for a perio of time an pa/ment re2arin2 that
use. 9ompanies woul prefer to call somethin2 the/ 0ou2ht a lease 0ecause then
the/ can euct pa/ments. :lso, then, for =::P purposes, /ou o not ha!e to list
it as an e3pense when /ou 0u/ it, 0ut /ou can sprea the rent out without ta%in2
a epreciation e3pense. :lso, on#t nee to ha!e lease on /our 0oo%s as a
lia0ilit/.
a. *perating (ease 4 authori5es tenant to use propert/ for e>ne perio in
e3chan2e for rental pa/ments o!er that time. *his 2oes on the lessor#s 0oo%s
as an asset an not on the lessee#s 0alance sheet. 1ease pa/ments are
treate as e#$enses when $ai%. ,hort term leases are alwa/s operatin2 leases
0ecause the/ o not ha!e an/ inicia of ownership. *he a!anta2e of this %in
of lease is that it has little impact on the 0alance sheet. 6ost _re2ular_ leases
fall into this cate2or/.
b. Capital (ease 4 2reate% as if Cessee ac'uire% $ro$erty an% owns it. :ppears
as an asset on the lesseeQs 0alance sheet. *he asset an lia0ilit/ must 0e
reporte on 0alance sheet. *he lia0ilit/ is reuce o!er time 0/ the full
amount of the lease pa/ments less some portion thereof (the appropriate
amount to account to interest 2i!en the conte3t$.
4 :t time /ou acquire the asset, /ou must<
&e0it present asset account FFF
9reit lia0ilit/ for it FFF
4 'ach time /ou pa/ _rent,_ /ou must<
&e0it lia0ilit/ FFF
&e0it interest e3pense (epreciatin2 the asset$ FFF
9reit 9ash FFF
2. - prong testA *he si2ni>cant iAerence 0etween these 2 %ins of leases is the
iAerent %in of impact that each of these has on assets an lia0ilities on the
lesseeQs >nancial statements. : lease ha!in2 an/ one of these characteristics will
0e eeme a capital lease< Jasically as7in, whether the 2enant is Actually buyin,
the $ro$erty-
i. 1essee ens up ownin2 propert/ at en term (transfer at an/ time urin2
lease$.
ii. &argain PriceA 1essee has the ri2ht to purchase for option price that is
clearl/ a 0ar2ain price an the parties %now that the price is a 0ar2ain
when the/ si2ne the a2reement. (.e. for O1, for O1000. &e>ntion< a
purchase option such that the e-ercise o! that otion buy the
otionee is e-tre&e/y /i:e/y at the time the lease is si,ne%
45
'3, 1N75 where cost of propert/ is O26 an 2i!e the persion the
option to 0u/ after 2000 for OD.86 rule of 72#s inicate that in 25
/ears somethin2 e!en at HZ inCation rate will ou0le in !alue[ 2his
can sometimes be a %iMcult %etermination an% very subjective
%etermination ()ote that e!en if this prices oes not turn out to 0e a
0ar2ain, what counts was the intene 0ar2ain at the time that the
_lease_ was e3ecute.$
'3. 2 Mhen sale, the a!era2e of H apprasials an then 2et 10Z oA of
the a!era2e of those H appraisals is this a Bar2ain Price or )+*S
Brot< sa/s )+ 0ecause 10Z is reall/ not that much of a iscount in
terms of transactional costs, real estate sales ta3es, etc. *herfore, at
10Z oA the option is not e#tremely li7ely to e#ercise- 25Z is more
li%el/ to 0e e3ercise.
iii. Ko. (ong is t!e leaseQ is it C5V or more o# t!e remaining use#ul
li#e o# t!e propertyQ J*TEA ma;e all determinations at t!e time t!e
lease is signed. Jote also5 in calculating .!en t!e term is5 !a$e to
include W:re the options such that the other part/ is e3tremel/ li%el/ to
e3ercise[i.e.< a$ hu2e penalt/ for not e3ercisin2; 0$ 0elow mar%et rate for
si2nin2 it[ *erm lease co!ers perio of time that is 2reater than 75Z of the
useful life of the propert/. *o qualif/, the term must 0e 2uarantee. an
the fact that the lease co!ers such a portion of the useful life of the
propert/ must 0e e!ient at the time that the lease was si2ne.
i/. Present $alue o# total payments o# rent due under minimum lease
must add up to 9%V or more o# t!e #air mar;et $alue o# t!e
property on t!e date t!at t!e lease is signedX)+*'< assume that an/
renewal perios that are so e3tremel/ li%el/ to 0e e3ercise, then, the/
must 0e inclue. *he num0ers that count in this e!aluation are all rental
pa/ments that are 2uarantee (i.e. those that will clearl/ 0e mae$ an
therefore, this ma/ inclue all rents ue urin2 an/ renewa0le terms that
qualif/ as K!er/ apparentL uner "H.
J*TEA if :)G of these D factors are met, the cost of the lease is incurre as a lia0ilit/ an
then as rent is pai, it can 0e e3pense an epreciate. Vowe!er, as Brotman e3plains
immeiatel/ 0elow, remem0er that a lease that oes not actuall/ meet these factors ma/,
eAecti!el/, still reCect si2ni>cant o0li2ations of the tar2et compan/.
/. Imart '3ample E@ample o# !o. c!anges in !o. somet!ing is
.ritten do.n 2accounting rules7 c!anged t!e .ay +usiness
+e!a$es 3t!e tail .agging t!e dog47Pres2ie (former I6:@*$ ecies to
compete with MoolMorth#s. Mants to compete with Moolworth#s 0/ 2oin2
into the su0ur0s an pro!iin2 free par%in2 etc. :t the time, there were not
too man/ free stanin2 shoppin2 malls. "eal Estate SyndicationA Imart
woul 2et someone to 0u/ a store an lease it to them. '3. 0u/ a store for
O16 an ta%e out H0/r 6ort2a2e p/met at O25IRmonth. I6:@* sai that
the/ woul rent out the store for O26IRmonth which woul then permit the
0u/er to secure the mort2a2e from the life insurance compan/ (0ecause
the 0u/er was 2uarantee a price that e3ceee the O25IRmonth.$ *his was
!er/ fa!ora0le to I6:@* 0ecause the/ i not ha!e to show it on their
(ncome ,tatement as a 1oan. =::P comes in an e!ises a D4pron2 test
wherer, if an/ one of D4conitions are satis>e, then it must 0e consiere
a capital lease.(,ee a0o!e$ (n earl/ 70s, ecie the/ i not want to ha!e
to epreciate the properties in which their stores were locate. )or i
the/ want these lia0ilities on their 0oo%s, so the/ structure leases as
operatin2 leases an mae sure that the/ woul not 0e force out of the
46
space at the en of their terms. 1ease, e2, for 2NRD0 /ears of life.
,/nicator 0u/s lan an 0uils 0uilin2, sells to pension plan (nonta3a0le
entit/$ for OH0%. ,ell propert/ to s/nicator for OD00%. '!er/ one in!este
with ta3 euction in min (F6P OD00%$. (@, 0lew these out
/i. 2Be Mar/ of$< *88H&alance S!eet 8inancing e!en thou2h it is an
o0li2ation of the compan/, it is not an o0li2ation for =::P purposes, e!en
thou2h it ma/ 0e a !er/ si2ni>cant o0li2ation. For e3ample, leases that are
still operatin2 leases can still ha!e VB=' o0li2ations attache to them,
e!en if the/ o not actuall/ qualif/ uner the conitions for a capital lease.
*herefore, we must %eep in min these P'@G si2ni>cant le2al lia0ilities that
6:G ha!e serious implications on !aluation of companies when we are
0u/in2Rsellin2 corps or lenin2 OO.
$. (ong Term :e+t 4 (nclue lon2 term 0orrowin2 on 0ons or 0an% loans, inclue
mort2a2e on F:. ,et forth as a lon2 term lia0ilit/ on 0alance sheet. :n/ portion of
a lon2 term e0t pa/a0le within the ne3t accountin2 perio (/ear$ shoul 0e set
forth as a current lia0ilit/ uner K9urrent Portion of lon2 term &e0t.L
)+*'< 11R6R01 a lot of accountin2 is eterminin2 what aEustments nee to 0e mae at
the en of the perio
E. "etiree &ene?ts 4 Pension Plans )ot actuall/ a Kconti2ent lia0ilit/L 0ecause it ma/
actuall/ 0e a contractual lia0ilit/. *o qualif/ as a conti2ent lia0ilit/, it must 0e B+*V
pro0a0le an estima0le. (n the case of @etiree Bene>ts, the lia0ilit/ is often times
e>nite.
1. :e?ned Contri+ution Plan 4 system where the em$loyer woul% $ay in a set
amount to the em$loyee+s retirement / health $lan. &ri!en 0/ ta3 consierations.
*here is no 2uarantee of what /ou will 2et. &epenent on emplo/erQs
contri0ution. @equire or allow emplo/ee to contri0ute. "#$ecte% value of $ayout
(i-e- the eventual bene8t to you chan,es as com$ensation levels an% eli,ible
em$loyee&s %o. *here are onl/ a few of these plans left. 6ost D01(%$ matchin2
plans o not show up on the 0alance sheet.
2. :e?ned &ene?t Plan H system where the em$loyer woul% contribute a 8#e%
$ercenta,e to an em$loyee+s 8nal salary. For e3. 2et an amt equal to 1an 2RH of
/our annual a!2. salar/, multiplie 0/ the " of /ears /ou ha!e wor%e there that
was equal to /our annual pa/ment upon retirement.
VGP+< a law >rm hires a 25 /ear ol[
(1$ 6ust recor the present !alue of the estimate pension return.
:ssumptions<
1. Vow lon2 is someone 2oin2 to wor% at a 2i!en >rmS
2. ,alar/ trens o!er a certain amt of /earsS
H. &iscount rateS
'3, 9ompanies in the earl/ 70#s reali5e that the/ coul eclare 0an%ruptc/ an then
fuc% o!er the pensioners. )ow, we ha!e the Pension Bene>t =uarantee Boar. ,ince
the a!ent of this 0oar, the assumptions that corps ha!e mae ha!e chan2e. 1$
pple li!e lon2er an wor% lon2er. 2$ 2reat rate of inCation (where wor%in2 pple is not
increasin2 as much as the OO that is in!este what resulte is that 9orp#s ha :
1+* more OO in their pension funs than the/ neee. *his le to a lot of corporate
raiin2 of o!er4fune pension accounts in the 80#s. ,ee *he 6o!ie Mall ,treet
where the airline ha a hu2el/ o!er4fune pension account.
Prior &ene?t Cost must 0e attene to when a 9o starts a pension plan. For e3.
9orp starts a plan that is 1.66Z 3 /ears of ser!ice 3 a!2. salar/ of last 5 /ears of
ser!ice. (f ha to put that amt of OO in at the outset, it woul 0an%rupt the corp. (n
47
this scenario, =::P loo%s li%e le2islati!e an polic/ settin2 law. 1ia0ilit/ X future
o0li2ations 0ase on prior actions. (f 9orps ha to ta%e massi!e e3pense on a/ 1,
the/ woul ne!er 0e incenti!i5e to start pension plans. *herefore, =::P sa/s that
prior ser$ice costs can 0e amorti5e o!er the career life of the emplo/ee as a
char2e a2ainst earnin2s o!er the remainin2 term of ser!ice for a 2i!en emplo/ee.
P+()* V'@'< *here are elements of =::P that are theoreticall/ Eusti>a0le, 0ut stan
more for the proposition that the/ are political compromises (i.e. here, Pension Funs
are 2oo$. *his emonstrates that much su0Eecti!it/ an Eu2ment an e!en political
compromise 2oes into what accountin2 num0ers sa/.

*his t/pe of plan was not particularl/ popular 0ecause wor%er oes not 2et more if his le!el
of compensation rises 0ecause pa/ments are set. ,till e3ists in a lot of union run inustries.
9an calculate how much the emplo/er nees to contri0ute on an actuarial 0asis an at the
en of each /ear, calculate the present !alue of what is neee. GAAP says that you
cannot account for it on a $ay as you ,o metho%. Presume interest rates in actuarial
assumptions resulte in o!er fune pension plans.
a. 4ver fun%e% Pension fun% 4 assets are ,reater than liabilities. (n 1N80Qs,
corp raiin2 in!ol!e ta%in2 o!er fune pension funs 4 accountin2 for this
as free asset on 0alance sheet allowe people to ta%e it (o!er require
'@(,: amount$. ,houl put in separate trust, not cash an not free asset.
H. Post @etirement Vealth Bene>ts< :ccountin2 was e!elope on pa/ as /ou 2o s/stem.
*he theor/ was that the amount to 0e pai in was small. 1han,e in GAAP * show in
account by $romises ma%e. (n 1NN5, someone >2ure out that in 200N, most 0a0/
0oomers woul retire si2ni>cant lia0ilit/. F:,B ecie that companies shoul
ha!e to account for these future costs an e!er/ compan/ was 2i!en the chance to
sprea this hit out or to ta%e a one4time hit to their >nancial statements 0ecause the
countr/ was in recession an/wa/. For e3ample, 1oo%in2 0ac% to (B6 o!er 1 /ear in
earl/ N0#s their 1 /ear earnin2s roppe oA tremenousl/. 199,H93 Kistorical
8inancial StatementsA 1ar2e 9orps use to pa/ for retiree meical 0ene>ts. 65;
/rs ol all :mericans 2et 6eicai (an, the aitional cost a0o!e 6eicai is not
that si2ni>cant$. *he e3pense was not 0oo%e an future lia0ilit/ not anticipate[
,oon, when someone ereco2ni5e that the 0a0/40oomers woul retire an create
VB=' costs, =::P passe a rule that eclares must 0oo% the actual e3penses
(meical$ of retirees. 9an amorti5e the costs o!er 10 /ears +@ ta%e a 14time cost.
1om$anies chose the one time hit. *ren is now for co#s to stop ma%in2 these
promises.
D. EUect o# C!arging Employee edical &ene?ts against cost any Corps5
includingA Bnis/s 9orp< stoppe pa/in2 for emplo/ee 0ene>ts (meical$ an sue 0/
'mplo/ees. 9t foun that these emplo/ees were emplo/ees at will the corp not
o0li2ate to pa/ meical 0ene>ts[
5. Mhen a compan/ pa/s out 0ene>ts, it reuces a lia0ilit/. :ccrual of lia0ilit/ is
consistent with =::P.
6. 6assi!e e!olution of retirement 0ene>ts 4 :s wor%ers 2et oler, too% pension oA
0alance sheet (D01(%$$ mone/ 2ets in!este in stoc% mar%et (0ecause can#t 0reach
> ut/ to self$ an ae liquiit/ to stoc% mar%et.$ ,hows importance of
accountin2.
7. *oa/, companies must ta%e an estimate char2e to earnin2s an then, when actual
num0ers come in, the/ Eust reuce the lia0ilit/
48
>. (oss Contingencies 4 contin2ent lia0ilities, such as lawsuits. For e3ample, law/ers
2et letters from auitors each /ear as%in2 for an/ penin2 liti2ation an then as%in2
how pro0a0le an for what amount the liti2ation is li%el/. :lso, note that 0ein2 sue
is also part of oin2 0usiness. :n/ time that potentiall/ sellin2 a an2erous prouct
into commerce, proucts lia0ilities suits are a cost of oin2 0usiness. :ccients at
Malmart +@ at Pu0lic transportation companies (for e3ample estimate the amount of
liti2ation penin2, the percenta2e !ictor/ an the amount of insurance eucti0les
that will 0e lost$. *his is mone/ that /ou will li%el/ owe to someone for somethin2 in
the future. Gou will either not %now whether /ou will owe it, when it will 0e ue, or
how much it will 0e (total !alue$. Aou only accrue this as a liability when the loss is
both $robable an% reasonably estimable. H possi0ilities uner =::P<
1. Ciability is both a $robable an% reasonably estimable amount (e.2., warranties 0/
For$. *herefore, companies must 0oo% these amounts.
'3ample< LarrantiesIGuaranteesA Brotman sa/s that it is ama5in2 how precise
their warrant/ e3penses will 0e most of the time the recall will not 0e as
e3pensi!e as For or Firestone in pre!ious /ears.
=6 2i!e three /ear Marrant/ it has a 2oo iea of how much it will ha!e to
pa/ o!er time. =6 recors lia0ilit/ at the time of the sale
'3< =6 %nows warrant/ will 0e 5000 ma%e the followin2 entries<
&e0it 44 warrant/ e3pense 5000
9reit lia0ilit/ 44 (warrant/ cost to 0e pai$ 5000
Mhen compan/ has claim of FFFF mae uner the warrant/<
&e0it lia0ilit/ KMarrant/ Pa/a0leL (warrant/ cost to 0e pai$ OD000
9reit K9ashL cashRother assets OD000
2. Ciability is $robable but not estimable no entries are require +ut isclose in
footnote.
$. 3f only estimable within a ran,e@ boo7 it at the low en% of ran,e. (*his is not an
attempt to ta%e a conser!ati!e approach 0ut 0ecause usin2 estimates, onl/ the
low en is pro0a0le an estima0le.$
%. 3f less than remotely $ossible@ %o not %o anythin,.
&. :nother t/pe of e3ample woul 0e mone/ li%el/ to 0e owe in lawsuits, howe!er,
/ou onQt e!er want /our >nancial statements to re!eal that /ou e3pect to 0e
_wron2_ in a 2i!en amount 0ecause that coul 0e percei!e as an amission of
2uilt.
F. *his has 0een a tremenous source of 9ompan/#s Kfu2in2L the 0oo%s for
e3ample, e!er/ compan/, when the/ o a mer2er, the/ ta%e a loss contin2enc/
e3pense now an write it oA the/ will then tremenousl/ o!er4estimate an use
that initial write oA to co!er operatin2 e3penses later on.
&rotman9s Peac! &ottom Juclear Electric Plant .!ile at :ec!ert E@ampleA
*he )@9 ()u%e @e2ulartor/ 9ommission$ shut the Power Plant own 0ecause
of fuc% up
49
1his reflects the cost
of paying off the
warranty liabilities in
7'03
P'9+ was sue 0/ 6:)G 9os that were 2uarantee electricit/ from P'9+
uner contract who ha to 2o elsewhere an purchase the electricit/.
Pro0lem< how the isclosure is mae\\\/ou ma/ nee to ta%e an e3ception
to =::P in this scenario an simpl/ sa/< we were sue, we are !i2orousl/
efenin2 it, we 0elie!e we will win. *his is calle a 0uali?ed opinion an
companies o not lo!e to issue it 0ecause mar%ets, leners, etc o not li%e
quali>cations. *he Going Concern Ouali?cation is the worst quali>cation
0ecause it implies that the compan/ ma/ )+* continue with its re!enue
earnin2 acti!ities. For e3ample, some of the airlines this /ear ma/ ha!e 2oin2
concern quali>cations this /ear 0ecause the/ are oin2 so 0al/. (nstea, the/
li%e unquali>e opinions.
M. Stoc; *ptions 4 options 2i!e one the ri2ht to 0u/ a certain num0er of shares of a
stoc% at a certain price at some time in the future. +ptions ha!e intrinsic R face !alue
an can 0e sol on the open mar%et. +ptions t/picall/ ha!e an e3piration ate.
+ptions are commonl/ use as e3ecuti!e compensation an are a wa/ to create
incenti!es for e3ecuti!es to increase the !alue of the compan/Qs stoc%, there0/
increasin2 the !alue of oneQs option. +ne ma%es a pro>t on the option when one
cashes it in an 0u/s stoc% at a 0elow mar%et price. &iAerence 0etween an
emplo/ee stoc% option an a warrant 2rante to a !enor that is a ri2ht to 0u/ a
num0er of shares at a set price 0efore a certain ate< emplo/ee 2ains the moti!ation
to ma%e the compan/ ha!e a hi2her !alue while the !enor ma/ onl/ 2ain the
incenti!e to 2i!e the compan/ 0etter treatment 4 an this is not as stron2 of an
incenti!e
444 L!en t!e company grants an option to an employee5 t!e company
must only account5 on its ?nancial statements5 #or t!e diUerence in
$alue5 i# any5 +et.een t!e stri;e and mar;et prices. *his is one throu2h a
char2e to the compan/Qs earnin2s. +therwise, the compan/ oes not ha!e to
char2e an/thin2 to earnin2s. Brot< sa/s that this ma/ 0e a little >sh/ 0ecause
e3ecuti!es are actuall/ emplo/ees an the/ want to 0e a0le to 0e 2rante as
man/ options as possi0le an not ha!e to recor them as a char2e a2ainst the
earnin2s statement until e3ercise.
'3. Mhen 6icrosoft ha man/ outstanin2 options to emplo/ees (when the
):,&:Y collapse$, there were man/ hi%%en costs that were not theretofore
accounte for. *o ascertain hien costs, thin% a0out it in terms of G+B
ownin2 the entire compan/ an su0tract the !alue of options issue at stri%e
price from net !alue.
444 Lit! an option I .arrant granted to a $endor, that must 0e char2e to earnin2s as
an e3pense (warrant e3pense$. 1ater, when the outsie !enor e3ercises the option, there
is no char2e to the earnin2s 0ecause it has alrea/ ta%en that e3pense in. :n/ compan/
that 2rants options is therefore o!erstatin2 its earnin2s to a certain e2ree 0ecause of
these outstanin2 an unaccounte (on the 0alance sheet$ for options. *his is a prett/
su0stantial eparture from =::PQs 2eneral principles. *herefore, companies ha!e to
account for most of this throu2h isclosure in footnotes. Why is this ,enerally un*acounte%
for? Jecause they are not or%inarily re'uire% to be recor%e% on the balance sheet as a
liabiloity or on the income statement as an e#$ense-
'3ample< at the en of the /ear, /ou ha!e the ri2ht to 0u/ 70I shares of
9(,9+ at O20Rshare (the current price as of toa/, 11R6R01$ an ha!e the
ri2ht to e3ercise that option o!er the ne3t 5 /ears. +ptions on 9(,9+ are
re2ularl/ trae on the open mar%et an, to 0u/ an option to trae 9(,9+
50
at O20 can 0e purchase at OH, for e3ample. Mhat amount of
compensation can 0e etermineS Blac%4,hoal +ption Paluation 'quation.
o (s it iAerent if we 2i!e ,toc% i.e. 10I shares at O20 shoul we
recor this e3pense
o Vow a0out when /ou are an outsie emplo/ee an 2rante stoc%
options, shoul this 0e e3pense.S
B@+*< notes that all these thin2s shoul 0e e3pense 0ecause, of course
the/ ha!e !alue 0ecause the/ ha!e 0een ne2otiate. :ll H of these thin2s
are 9+6P'),:*(+) the compan/ has 2i!en awa/ somethin2 of !alue.
I33- 1a$ital Accounts * Accounts in which owners& interest in entity is re$resente%-
Balance of 9apital :ccounts X *otal :sset :ccounts minus *otal 1ia0ilit/ :ccounts
(function of funamental equation$
:. =roups of 9apital :ccounts<
1. 9ontri0ute irectl/ to entit/.
2. =enerate 0/ operation of entit/#s 0usiness o!er time.
H. @eCect aEustments that arise from non4operatin2 e!ents
D. 9omments< 1imite 1ia0ilit/ 9orp (119$ 4 Fle3i0ilit/ of a corporation 0ut ta3e as a
partnership. )o lia0ilit/ for corporate owner. :s a result, not as man/
partnerships an/more, e3cept for those that are small an real4estate relate. ,4
9orp 4 Pure corporation that elects to 0e ta3e as partnership an where all
income passes throu2h the corporation an 2oes irectl/ to the shareholers.
6. Capital Accounts "eMecting Contri+uted CapitalA Par Dalue and (egal
Capital (pro0lem is recorin2 an aequatel/ protectin2 creitorsQ ri2hts so the le2al
capital re2ime was create.$
1. 1e2al 9apital @e2ime 4 create to protect creitor#s reliance. Ce,al ca$ital is the
total $ar value of the shares issue%- : require 0ase amt of OO in the co. ,o that
pple who eal with the 9o can loo% at certain 0oo%s an %now how much OO were
there. :ccountin2 itself ne2ate the nee for le2al capital. when 9orporations
were create i.e. a >ctitious le2al creation, we wante pple to %now what was
there. *herefore, 0Rc the corp ha to re2ister with the state, it ha to re2ister how
man/ shares of stoc% were to 0e issueUPar was Eust a " 44 a stateR0ase amount
of stoc%. 1e2al capital was the par amt of stoc%. For e3ample, in the past, the
amount in the funs of the corp coul )+* 2o 0elow the amt of le2al capital.
6oreo!er, no funs coul 0e use from le2al capital to 0e pai to shareholers or
other creitors. Mh/ woul someone want to pa/ i!iens rather than salar/S
()o Feeral (ncome *a3 until 1N16$. 9oncept of le2al capital is important toa/
0ecause there are still some states that ha!e 0i5arre le2al capital laws i.e.
restrictions on i!iens that are 0ase on historic notions of !alue of le2al
capital. )o i!iens ma/ e!er 0e pai out of par !alue. *he requirement was
esi2ne so that companies woul alwa/s ha!e mone/ on han with which to pa/
e0ts (concept of equita0le sol!enc/ 4 not lettin2 corps pa/ out i!iens that
woul lea!e them with no mone/ to pa/ e0ts$.
Be !er/ careful as to what t/pes of i!iens can 0e allowe wR smaller companies.
2. )+* 9+P'@'& () 91:,, 2001 (&' went further 4 companies ma/ onl/ pa/
i!iens out of current /earQs net income an prior /earQs net income. *his is
calle a nim0le i!ien.$ Vowe!er, with the help of creati!e law/ers, companies
0e2an to lower par !alue an then sell stoc% at a premium o!er par, functionall/
estro/in2 this purpose.
51
$. )ote that le2al capital has nothin2 to o with =::P. *oa/ i!iens are not that
important 0ecause most companies ha!e stoppe R ne!er starte to pa/ them out
to shareholers 0ecause corporations can use that mone/ to rein!est in the
corporation, ma%in2 it more !alua0le an ini!iuals can sell stoc% when the/
nee to reali5e some cash.
a. ,toc% can#t 0e issue 0/ corp for an amount of consieration less than the par
!alue of the stoc%.
b. &iscretion of B+& to eclare an pa/ i!iens is constraine 0/ amount of
le2al capital. 9an#t pa/ out le2al capital.
c. 1imits %in of consieration that can lawfull/ 0e pai for shares (cash an
other tan2i0le propert/$. &' retains !esti2es of this 0ut D0 states ha!e si2ne
onto @6B9: (2i!es corps more latitue$.
9apital X @esources from which to run /our 0usiness the OO or other reail/ a!aila0le
assets from which a compan/ operates. *he reason /ou nee capital is to continue /our
pro>t ma%in2 operations. 9an 0e< cash in the 0an%, lines of creit, e0t. 9apital can 0e
secure in !arious wa/s. (.e. as% how 0usinesses ma/ 0e capitali5e. *oa/, companies are
capitali5e throu2h B+*V &e0t an 'quit/ Financin2. +ne of the reasons for this is ta3es. (f
OO are put in to the corp in the form of equit/, in orer to 2et a return, /ou woul ha!e to
2et that in a i!ien (which is su0Eect to ou0le ta3ation$. 9orporate ta3 rate (H5Z$ ;
ini!iual income ta3 rate on the i!ien (27Z$ therefore, 100O of income is reuce to
O28.
:nother e3ample is ma%in2 a loan to /our compan/ in e0t. :ssume the 9orp ma%es
O100 an the/ pa/ /ou interest on the O100 /ou lent them. *he 9orp ta%es an
interest euction as an interest e3pense an then /ou 2et ta3e for the interest
the/ pa/ /ou as income (at D0Z$ therefore, there is )+ ou0le ta3a0tion s/stem
here.
*he ou0le ta3ation s/stem has incenti!i5e in!estment in 9orps in non4traitional, non4
equit/ wa/s.
Penture 9apitalists X pple who pro!ie capital, earl/ on to earl/ sta2e !entures an the/
also pro!ie a lot of 0usiness support (how to hire emplo/ees an run the 0usiness.$ B@+*<
Kpple who steal /our 0usinessL Bsu, the 2oal is to 2et the 9orp more pro>ta0le so that there
is an (P+ or somethin2 else. *herefore, the P9#s 2et their ori2inal OO 0ac% an the/ ha!e a
sta%e in the new compan/. '3. (nternet an P9 cra5es. Paul :llen#s P9 >rm KPulcanL.
*oa/, P9#s ta%e con!erti0le e0t in the 9orp. *he/ ma%e a loan to the corp at a fairl/ low
interest rate (not pa/a0le until later$ :)& it can 0e con!erte, i.e. the 9orp can chan2e the
o0li2ation into an equit/ status. 9on!erti0le e0t is 2oo 0ecause it ties /ou in to the
upsie ris% 0ut pro!ie protection if the in!estment (corp$ fails. P9#s are happ/ now that
the/ ha!e e0t o0li2ors 0ecause this comes >rst in 0an%ruptc/ o!er equit/ holers.
T!is is important +ecause a lot o# t!e transactions t!at .e .or; on .ill relate to
!o. companies secure t!eir capital i.e. t!eir operating resources. Business issues
are more important here than the :ccountin2 (ssues.
EEFA T!e traditional types o# s!are!olders9 e0uity are not .!at t!ey used to +e
loo; at t!e +alance s!eet care#ullyY for e3ample< su0orinate e0t; preferre stoc%;
Bnercapitali5e X /ou o not ha!e enou2h resources to run /ou 0usiness as a 2oin2
concern. '2. :irlines after ,ept 11 attac%s, there was news that the/ onl/ ha enou2h OO to
2et them throu2h a certain ate.
Mhat is parS +ri2inall/ intene to 0e le2al capital. ]par X le2al capital^ Mhat /ou woul
initiall/ sell the share for. 9orporation coul ne!er sell stoc% for less than this state
52
amount per share of stoc%. 6ost states ha laws prohi0itin2 people from pa/in2 i!iens
out of par !alue (must ha!e earne surplus$. But, then someone ha iea that sellin2 share
for more than par !alue woul 0rin2 aitional pai4in capital. Par !alue oes not reall/
mean an/thin2 an/more. ,ometimes franchise ta3 is tie to the num0er of shares issue,
0ut this is 0a for corporations an e3plains wh/ the/ usuall/ mo!e to &elaware.
2. @6B9: eliminates concepts of par !alue an state capital an eliminates the
earlier rule eclarin2 certain %ins of propert/ ineli2i0le (an/ tan2i0le R intan2i0le
propert/ are o%$. )o istri0ution ma/ 0e mae if<
i. E0uity 1nsol$ency Test 4 corporation woul not 0e a0le to pa/ its e0ts
when the/ 0ecome ue in the usual course of 0usiness. ]fair !alue of assets
\ fair !alue of lia0ilites^ +@
ii. &alance S!eet Test H (f corporation assets woul 0e less than sum of
lia0ilities plus amount neee if issol!e for preferences of senior equit/
securities
iii. &elaware has not /et aopte @6B9:. @6B9: has 2 tests 0ecause it lar2el/
ispenses with an/ reliance on =::P 4 2oo.
%. &elaware comes up with nimble %ivi%en%s 4 Gou o not ha!e to ha!e owner#s
equit/ to pa/ i!iens 4 /ou can pa/ out of pro>ts mae in prior 2 /ears. (*his
s/stem was esi2ne so that creitors coul %now that the corporation woul 0e
a0le to pa/ its e0ts as the/ 0ecome ue an woul not 0e a0le to pa/ itself
0efore it pai its creitors$.
&. +ther *ests 6an/ states use (nsol!enc/ approach (i.e., when compan/ is
insol!ent, loo% 0ac% at transactions to see what happene$.
i. Bniform Frau 9on!e/ance :ct
ii. Bniform Frau *ransfer :ct
iii. '3ample< ma%e a transfer of propert/ for less than it#s worth when /ou#re
insol!ent. 1aw will sa/ this has enou2h attri0utes to 0e frau. 9reate
entities that seeme insol!ent e!en when the/ were not.
F. Funamental component is shareholer equit/. ,hareholer equit/ in accorance
with =::P is not necessaril/ the most meanin2ful >2ure< =::P 9omponents (a
an 0 are contri0utions to capital$<
a. 9ommon ,toc%
b. :P(9 (:itional Pai (n 9apital 4a%a 9ontri0ute 9apital in '3cess of Par
Palue$.
i. '3ample< (f stoc% has par !alue, multipl/ " of shares outstanin2 times
the par !alue. 100 shares with par !alue for O5000. 6a%e a left entr/ in
9ash of O5000 an ma%e ri2ht entries in common stoc% for O100 an in
:P(9 for ODN00.
ii. )o par !alue, either B+& states amount for state capital account or left
cash entr/ an ri2ht common stoc%s (no par !alue$. ,ee p. 117
c. +ther 9omponents<
-,. #etained !arnings
-3. AnrealiBed Iolding gains
--. @inority Interests
7. Capital Accounts "eMecting Earned CapitalA "etained Earnings 4 see%s to
reCect amounts contri0ute 0/ corporation o!er time. 9umulati!e 'arnin2s 4
&i!iens to ,V X @etaine 'arnin2s. PW1 account 2ets close into the @W' account.
53
?. Capital Accounts "eMecting Ad>ustments to SK E0uityA 6ost acti!it/ is reail/
shown on 9apital :ccounts @eCectin2 9ontri0ute 9apital (par !alue an le2al
capital$ an 9apital :ccounts @eCectin2 'arne 9apital (retaine earnin2s$ 0ecause
the/ eal with contri0utions to ,hareholers an @etaine 'arnin2s. But, acti!ities
unrelate to asset R lia0ilit/ or income R e3pense accounts are recore irectl/ onto
the ,V equit/ account (not run throu2h income statement or 0alance statement
>rst$. (For e3ample, currenc/ is e!alue in countr/ where compan/ operates; ,V
equit/ reCects ra2 on contri0ution of earnin2s to ,hareholer 'quit/.$
E. ,toc% ,plits R &i!iens< these ha!e no eAect on the !alue of the compan/
9ash &i!iens an ,toc% &i!iens.
Mhen the &i!ien is issue the 9ompan/<
&'B(*,< K@etaine 'arnin2sL one of the +' accts that we ha!e the prior earnin2s of the
corp.
9@'&(*,< K&i!ien Pa/a0leL this has 0een a le2al o0li2ation a lia0ilit/ !is a !is
the corp.
Mhen the &i!ien is Pai<
&'B(*< &i!ien Pa/a0le (to increase lia0ilit/$
9@'&(*< 9ash (to reuce the asset of cash$ an increase the lia0ilit/
)+*'< that &i!iens can 0e pai out of @etaine 'arnin2s or :itional Pai in 9apital
(:P(9$
:P(9< :mount that /ou sell /our stoc% for in e3cess of capital. :mount that e3cees the par
!alue.
'3. 9(,9+ 9ommon ,toc% O76, an 9ontri0ute O in e3cess of par (:P(9$ X the
amount that the compan/ recei!e from stoc% issuin2 &i!iens aware.
'YB:*(+) 9+66+) ,*+9I ; :P(9 X :mt recei!e from stoc% issuance 4 &i!iens
a. &i!ien Process 4 'ntries<
4n efective/%eclaration %ate (when stoc7 ,oes 0 ! %ivi%en%<
@' 100
&i!ien Pa/a0le 100
3f you have run out of )"@ may have<
:P(9 100
&i!ien Pa/a0le 100
4n Pay Date<
&i!ien Pa/a0le 100
9ash 100 (if this was a cash i!ien$ aAect ,V equit/
4)
&i!ien Pa/a0le 100
9ommon stoc% 5
:P(9 N5 ((f this was a stoc% i!.$ oes not aAect ,V
equit/
0. 6ore on ,plits
Mith true stoc% splits, there are no accompan/in2 Eournal entries 0ecause
100 3 2 par now 200 3 1 par 4 there is no resultin2 chan2e in !alue. *here is
)+ 9V:)=' to Eournal entries ha!e not chan2e 0alance sheet or le2al
capital Eust now, e!er/one who ha 1 share, now has 2 shares.
ii. BB* companies can o stoc% split in form of stoc% i!ien (100Z stoc%
i!ien 4 where for e!er/ share of stoc%, another share of stoc% is issue$
54
entr/ 0ecomes same as a0o!e then. *his a!ois ,V !ote to chan2e articles of
incorporation which contain authori5e num0er an par amount. Gou coul
authori5e a lot of shares at ,V meetin2, 0ut par chan2e cannot 0e one 0efore
han.
iii. Mh/ 2i!e stoc% i!iensS
-5. *o ta<ation for Shareholders on receiing a diidend
-B. Increase Shareholder alue
-C. Increase the float the amount of shares outstanding and traded goes up. "he
greater the float the more li2uid the mar&et and the more that people %ill %ant to buy
the shares - therefore easier to trade
-8. *+ economic difference ho%eer for the co.
'F:6P1'< assume a 100Z stoc% i!ien we are pa/in2 out O1.D0 R share (!alue
of stoc%$ times the num0er of shares 0ein2 issue<
44 &e0it retaine earnin2s 0/ 2,800,000; creit common stoc% 0/ (2 million shares at
par !alue of O0.10$ O200,000 an creit :P(9 0/ 2,600,000.
44 :Eust 0alance sheet "Qs ()+*' 4 metho here is for small stoc% i!iens 4 i.e. less
than 20Z of the shares 4 p. 128$
D00,000 in common stoc% (200,000 ; 200,000$
H,D00,000 in :P(9 (800,000 ; 2,600,000$
200,000 in retaine earnin2s (H,000,000 4 2,800,000$
44 @esult is the same OD,000,000.
1ar2e ,toc% &i!ien 6etho< i.e. an/thin2 a0o!e 20Z of the outstanin2 shares.
(this is how most stoc% splits are actuall/ eAectuate$entr/<
@etaine earnin2s 200,000
9ommon stoc% 200,000
9ommon stoc% (a 200,000$ D00,000
:P(9X same 800,000
@etaine earnin2s (4200,000$ 2,800,000
44 @esult is the same OD,000,000.
0mall 0toc8 ?i/idend! 7orp has 1M shares of stoc8 outstanding trading at B1CCIshare "this is /alue# , it issues a %C,CCC
share di/idend to its shareholders , show the entry
?E6I1!Retained Earnings! B%,CCC,CCC
7RE?I1! 7ommon 0toc8 "amt of shares issuing L par# B%C,CCC
7RE?I1! '-I7 "balance of /alue of di/idends# B$,QFC,CCC
GGMar8et /aluation is used here because there is such a small amount issued that it, in theory, adds real /alue to the
shareholders.
0'ME 3=-O but, now a %CC,CCC share di/idend , which has a /alue of B%CC,CCC
?E6I1! Retained Earnings! B%CC,CCC
7RE?I1! 7ommon 0toc8! B%CC,CCC
55
5ote! we do 5O1 loo8 at the mar8et /aluation at all. 6rot! says that there is no real rationale here.
7ompany Paluation! 6rotman argues that often times it is not based on real timeIreal life /aluationYrather than how
business is operating on a day(to(day basis. Or does itR
=toc7/based #o*pensation>
5ow, from 1QQ& to March 2CCC, this was one of the most e+plosi/e period of stoc8 mar8ets in the world , more
pple than e/er owned stoc8 and prices shot up. 1his type of cultural domination, corporate e+ecs as celebrities, is
unheard of before 1C or 2C years ago. 'fter long prolonged period of no recession, pple started lea/ing the law
profession and no one wanted to go to a firm. E/eryone wanted to go to a ?ot.7om with 0toc8 Options.
7ompanies became so focused on stoc8 because they used it as currency to buy other companies, to attract and
retain personell. 1he perception of how a co9s stoc8 performance affected the company became a 3.ME issue.
1he glitN, then, was related to the /alue.
-erception is that a stoc8(split I0 important , how pple percei/e a co is important , i.e. low stoc8 prices may
signify more li:uidity.
o )ow, the popular companies ma/ chan2e< i.e. Malmart, has 2otten P'@G 0i2 in the
stoc% mar%et.
"eason .!y going pu+lic .as S** crucial in t!e past - years.
1$ )e!er unerestimate the KIeepin2 up with the Tones# FactorL i.e. rich want to 2et
richer
2$ Pple neee to 2o pu0lic in orer to %eep up with the pace at which other corps were
earnin2 capital.
Persistin2 Yuestion< Vow will the continue intereaction 0Rw pu0lic mar%ets an capital
in!estments chan2e the wa/ compan/#s operateS
9orin2ware (,/m0ol< =1M$ went pu0lic a while a2o an stoc% price went from O80 an
then the/ split man/ times after 2ettin2 into hi2h4tech >r0er4optics. *he/ le!era2e up a
lot of OO to 2et into this 0usiness of >0eroptics.
:s law/ers, ha!e to unerstan that the reaction of capital mar%ets is hu2e in orer to
represent clients.
1Q months ago, =ahoo had a higher mar8et /alue than -hillip Morris e/en though its real assets were worth crap. -hillip
Morris was distributing ?i/idends to its shareholders each year of B26illion
9hapter N has 0een on the test 0efore Financial ,tatement @atios.
'3am 120 points
2 sections; 12 multiple choice questions
10 short answer questions (reall/ short answers o a Eournal entr/, e3plain a Eournal
entr/, etc$ a couple in su04parts. Bse the amount of space that Brotman pro!ies.
&oo; is not used at ma;ing or grading t!e e@am class notes are #ar more
importantW!e does not gi$e a s!it .!at t!e +oo; says. 1# t!ere is a conMict5 go
.it! .!at &rotman says. :o not loo; at old e@ams #or su+stanti$e
;no.ledgeW
8or e@ample :epreciation #ocus on SJ1TS o# P"*:SCT1*J t!at is t!e most
typical met!od used in manu#acturing today.
I333- 6tatement of 1ash Flows (61F ** 7now what is in the statement of cash Kows@ not how to
%o itNNN
56
&alance s!eet is what /ou ha!e on a 2i!en ate at a 2i!en moment
1ncome statemnt 44 oes not relate at all to asset position or cash position 0Rc =::P ta%es acct
of accrual an eferral
Statement o# Cas!Mo. (!er/ imp$ is a reconciliation of sorts of Balance sheet an (ncome
statement if o not ha!e the cash or assets or 0orroa0wle a2ainst assets, ma/ not ha!e the
capital to run the 0usiness /et, /ou can still ha!e a stron2 operatin2 position. (nirect2 6etho
shows how it is a reconcilitation start with )et (ncome an then a 0ac% those items that i
not cost cash, 0ut reuce net income. 9oncept is to 2o from net income an then a to the
>2ure from net income those items that reuce net income 0ut i not use cash :)& to
su0tract those items that increase net income 0ut i not 2enerate cash.
'3 . &epreciation '3pense (a non4cash e3pense$ :&& 0ac% to )'* income :lternati!el/<
:ccrue @e!enues /ou ,BB*@:9* from )'* ()9+6'.
(t sa/s< we will ta%e a 0usiness an 0rea% it into H acti!ities<
o *perating Actiti$ities the most important of the H
Basic pro>t 2eneratin2 acti!ities, ta3es, interest, aministrati!e etc. oes not
inclue pa/ments of principal normall/ woul thin% that if 0orrow OO an
ma%e pa/ments on the loan this woul 0e in the same acct cate2or/ this
means simpl/, cash to operate, pa/ 0ills, 0u/ in!entor/ an 2enerall/ run the
0usiness. =ettin2 an re4pa/in2 that OO (the principal$ is not reall/ the cost
of oin2 0usiness, therefore, not an operatin2 e3pense, rather a >nance
acti!it/. 9ost of maintainin2 the heaquarters, ta3es, interest etc.
o 1n$esting Acti$ities e3. 0u/ propert/ plant or equipment ma%in2 an in!estment
in capital assets. 9ost of 0u/in2 a 0uilin2 for heaquarters
o 8inancing Acti$ities cashCows of >nancin2 acti!ities 0asicall/, 0u/in2 an
sellin2 capital assets
E@. last wee% we ha iAerent concepts of ha!in2 capital liqui resources
from which the/ nee to run the 0usiness e3. : co that sells stoc% the cash
that comes in is a Financin2 :cti!it/; e3. 2ettin2 OO from 0on issue; e3
repa/in2 OO from a 0on issue. '3. 0u/in2 stoc% in another compan/.
:n tr/ to etermine how much cash it 2enerate or spent in a 2i!en perio
Bnerstan how cashCows wor% thin2s that we ma/ thin% are 2oo actuall/ can ha!e a
ne2ati!e impact on cashCows.
'3. a 9orp has an ()9@':,' in :ccounts @ecei!a0le (:R@$ 0alance at en of /ear is hi2her at
the en. *herefore, /ou ha!e e3tene more creit than /ou ha!e 0een repai. *herefore, if
start with concept of net income (asales from cash :)& creit$, then, if :R@ increases, this means
that a portion of /our sales i )+* 2enerate cash.
For e3ample<
Balance of O0 at 0e2innin2 of /ear an 0alance of O100I at en of the /ear (/ou ha!e not
0een pai /et $
(f onl/ loo% at income statement, woul ha!e no iea whether there was cash 2enerate from
:R@ or not.
:nal/sts loo% at cashCow an etermine Ouality o# Earnings "atioXie. Vow much of the
earnin2 2enerate cash. Gou ma/ ha!e a compan/ that is er/ pro>ta0le 0ut oes not 2enerate
cash. +n the other han a compan/ ma/ loo% terri0le pro>ta0ilit/ wise, 0ut 2enerates : 1+* of
cash. '3. &ot.coms there was a V(=V positi!e cashCow from VB=' >nancin2 acti!ities ((P+s,
etc$ therefore, the an2er of these companies woul 0e loo%in2 at the 0alance sheet onl/
0ecause /ou woul see stron2 cash position, few lia0ilities an it ma/ appear to 0e a !er/ stron2
compan/. (f onl/ loo%e at (ncome ,tatement, /ou woul not 0e a0le to etermine the
tremenous amount of in!estin2 acti!ities that these companies ha. For e3ample, the *elecom
57
companies, Minstar, 6c9lou who raise VB=' amts of capital an i not ha!e a lot of
operations where the/ sol stuA an ha a lot of re!enue a lot of them 0uilt 0i2 >0eroptic
networ% an en2a2e in other ()P',*6')* :9*(P(*(',\ if loo%e at ()9+6' ,*:*'6')*, /ou
ma/ thin% that the/ were sort of pro>ta0lt, 0ut, if loo%e at ,*:*'6')* +F 9:,V F1+M,, /ou
woul reali5e that most of their OO were 0ein2 spent on in!estment acti!ities an most of their
cash was 2enerate from Financin2 :cti!ities not operatin2 acti!ities.
&S"J "ATEA which means the amount of cash e3pene urin2 a e>ne perio
(&+*9+6 spens O800I per month$
B@+*< pple ha!e to focus a2ain on cash 0ecause there has 0een a si2 rop oA in acti!it/ that it is
!er/ important to loo% at cash.
*'1'9+6 inustr/< Fall 1NN8, there were H leaers< 1ucent (the lar2est$, )ortel )etwor%s,
9(,9+ s/stems (which was the smallest in terms of sales an assets$.
&urin2 the 0uil4up o!er the last couple of /ears, the 1
st
2 in!este tremenousl/ in
in!estin2 in new companies. 9(,9+ instea 0ou2ht thin2s with their own stoc% instea of
Penor Financin2 44 . 9(,9+ is now ominant 0ecause the/ ha!e ,+ much cash. &urin2
the 0uil4up /ears where, all companies appeare to 0e pro>ta0le, 0ut,. 1ucent was
spenin2 an utili5in2 the cash while 9(,9+ was horin2 the cash an will 0ear the econ
ownturn 0etter an 0e a0le to mo!e forwar more easil/.
o Penor Financin2 (what 1ucent i$< ,eller >nancin2 i.e. sell stoc%. 9(,9+ sells
O16 of routin2 equipment to telephone co, 9(,9+ ma/ pro!ie them for the
>nancin2. *herefore,
&'B(*< :R@ O16
9@'&(*< ,:1', O16
o : tric% that the companies i to 2et aroun !enor >nancin2 is to 2o to a 1':,()=
9ompan/ where the 9orp 2oes to the 1easin2 a2ent an as%s the leasin2 corp to
ta%e referrals from customers who o not ha!e the cash to pa/ for 9(,9+
equipment. 9(,9+ then 2uarantees :B9 leasin2 that the equipment will 0e repai
mUi.e. 2ueanratees them in e0t.. *hen :B9 leasin2 pa/s 9(,9+ in cash.
*hen, 0ecause e0t onl/ nees to 0e recore if it is Kreasona0l/ estima0le
an pro0a0leL uner =::P when the telecom 0oom occurre, the e0t was
not !er/ pro0a0le an therefore, it woul not show up on 9(,9+#s >nancial
statement.
Catc!ing 3Stealt!4 Dendor 8inancing*herefore, as a law/er, /ou
must :,I what 2uarantees the compan/ has i.e. eterminin2 the
o0li2ations that ma/ not show up on the (ncome statement or Balance
,tatement
B' 9:@'FB1
&o not confuse (ncome from +perations with 9ashCows from +peratin2 :cti!ities
1$ E:1T:A HH 'arnin2s 0efore interests, ta3es epreciation an amoriti5ation. 44 K'&(*&:L
a s/non/m man/ times for K+peratin2 (ncomeL i.e. if ( were to 0u/ this 0usiness, what
woul ( ha!e to ser!ice m/ e0t. '3ample, Brot represente a leasin2 compan/ who ha
reasona0le access to capital. *he 0u/er compan/ ha a lot more access to capital an
therefore the interest cost of the compan/ was much less si2ni>cant to them. *his
inicates that, as far as pro>ta0ilit/ 2oes, interest an ta3es are relati!e epenin2 upon
the purchaser.
o &epreciation an :morti5ation are non4cash e3penses that relate to assets that
ha!e alrea/ 0een purchase o not reall/ eAect the compan/#s pro>ta0ilit/
oes not reall/ measure economic worth.
2$ But, on ,tatement of 9ashCows, interest an ta3es are ta%en into acct.
58
3&e s;eptical a+out pple .!o analy=e rat!er t!an do4 HH Tac% =ru0man an the telecom
0urst. Ve was the 2u/ who was consiere the most 0rilliant anal/st in the entire inustr/ saw
P'@G little of the 0urst. *herefore, 0e s%eptical a0out what anal/sts sa/.
*V' 'YB(*G 6'*V+& :)& 9+),+1(&:*(+)< Vow o /ou account for in!estments in other
compan/s there are H methos<
1$ (f a corp owns stoc% in another co, if own 1',, *V:) 20Z, account for it as an
1n$estment in ar;eta+le Securities
o '3ception if ha!e less than 20Z, 0ut ha!e eAecti!e or su0stantial control, then still
use equit/, one4line approach.
2$ E0uity et!od 21 line approac!7 HH (f own :* 1':,* 20Z 0ut )+* 6+@' than 50Z
(20Z to 50Z, inclusi!e$ use the 'quit/ 6etho. Bne rthis metho, inclue in income
statement, amount that is equal to proportionate share of /our in!estment in that
compan/. For e3ample, if own 1RH of a su0siiar/ who earns OH00I for the /ear, then
write own O100I
o '3, 0u/ 1RH
r
of a compan/ an pa/ O16 in cash.
:,,'* :cct<
Pay ;.@///@/// for ./>
r%
ownershi$ sta7e in a com$any
(n!estment in ,< O1,000,000 (e0it$
9ash< 1,000,000 (creit$
(n!estment in ,< O100,000
(ncome from ,< O100,000
(f recei!e a i!ien from , in the amount of OH0,000 orinaril/, the receipt of the i!ien
woul 0e the income e!ent 0ut, 0ecause /ou own more than 20Z of the compan/, /ou must
use the 'quit/ 6etho of :ccountin2 an therefore, an/ cash that /ou recei!e &'9@':,',
/our in!estment in the compan/
9ash< OH0,000
(n!estment in , (OH0,000$
H$ (f own more than 50Z Consolidated 8inancial Statements show all the income,
sources of re!enue an e3penses on /our (R, an show all of the assets an lia0ilities
on the parent compan/#s statement. (F own more than 50Z /ou 6B,* consiate an if
/ou own less than 50Z /ou 9:))+* consoliate.
o '3. (n!estment in , 0ut, /ou own 60Z 44 instea of the a0o!e metho a all
of ,#s assets an lia0ilities to /our 0alance sheet an therefore /ou, eAecti!el/
ha!e 100Z of the +wner#s 'quit/ on /our 0alance sheet . *hen, at the en of
the perio, create a 9+)*@: :ccount to su0tract D0Z of the assets an lia0ilities
an name it
o inority 1nterest in Su+sidiary if own a su0siiar/ more than 50Z, /ou
show 100Z of assets an lia0ilities on (ncome statement therefore, on 0alance
sheet, this entr/ reuces the proportional amount of the compan/ that /ou o
not owe. :n, on the income statement, /ou remo!e the proportionate share of
net income that /ou o not own. 9onceptuall/, the )'* amount is equal 0Rw the
'quit/ metho 1 line approach (which shows /our proportionate share of the
0ottom line$ !s. this metho, which eAecti!el/ is the same thin2 on the (ncome
,tatement, 0ut shows &ramatic chan2es on the Balance ,heet. *he concept
here is that /ou shoul onl/ show on a net 0asis the same percenta2e that /ou
own in a su0siiar/, 0ut, when /ou own more than 50Z, /ou must show all of it.
*herefore, if /ou own more than 50Z i.e. 51Z of a compan/, /ou can create the
59
appearance of increasin2 /our ,:1', tremenousl/ on /our (ncome ,tatement.
+n the other han, if own DNZ, onl/ show 14line on /our )et income sheet (as
a0o!e$ . *he thou2ht there is that if /ou ha!e more than 50Z of the ownership,
then /ou ha!e control, an if /ou control more than 50Z of the assets an
income, then /ou are allowe to show it.
Side JoteA Bntil 1NND the non4homon2enous rule allowe /ou not to consoliate a su0siiar/ with /our
own compan/ e!en if /ou owne more than 50Z, if the function of the companies were e3tremel/
iAerent. Pre41N76, B, car ealer tr/ to compete with Tapanese an therefore create non4homo2enous
companies who >nance car sales. *his woul create losses, 0ut, no in!estors care 0ecause =6 was
technicall/ a iAerent corp than =6:9 (the >nancin2 su0siiar/ that was losin2 a lot of OO$. B/ 1NND, so
man/ companies were a0usin2 this e3ception that the 2o!ernent 2ot ri of it. *herefore, )+M, if own
more than 50Z of a su0siiar/, it 6B,* 0e consoliate.
(nterestin2 Point in a true 50450Z Eoint !enture, the assets of the Eoint !enture ne!er show up on either
compan/#s >nancial statement. 9ompanies will tr/ to a!oi 9onsoliatin2 with start4ups, etc. 0ecause the/
o not li%e their Financial ,tatements 0ein2 aAecte 0/ factors outsie of their control. *herefore, in
:2reements an Marranties, there will 0e statements such that a partner is una0le to acquire more than
50Z of another compan/.
'. @ationale an +r2ani5ation 4 Bse to onl/ nee income statement an 0alance sheet to
unerstan >nancial conition of entit/. *hen e!elope the ,tatement of 9han2es in
Financial Position. Pro0lem with this (reconciliation of 0alance sheet an income
statement$ is that it i not reconcile 0/ cate2or/ the iAerent t/pes of thin2s that can
cause a chan2e. *he statement of cash Cows shows m2mt of cash.
-9. About E yrs ago( FASB changed to Statement of 8ash Flo%s. Basic purpose is to ta&e
cash and sho% ho% that account has changed during the year. Inoles cash and cash
e2uialents (short term mar&etable securities( other li2uid assets). S8F is so recent that
people do not focus on it. #esult is that people do not use it.
5%. 8an be used to detect end of the 2uarter window dressing( %hen a company might ta&e
loans or sell a poorly performing stoc&( etc. to try and sho% the company %ith more cash on
the end of period financial statements. "he balance sheet does not tell you %hat the
company loo&ed li&e on the day before the period ended or on the day after the end of the
period. "his practice %ould be disguised in the balance statement or the income statement.
51. "he income statement does not tell you ho% the reenues and e<penses relate to the
assets or ho% the assets are used to generate the reenues and e<penses( and it does not
tell you if the company is generating any cash. If there is a lot of accrued income - may hae
negatie cash flo%.
5,. #econciliation bet%een income and balance sheet - ta&es the net income and brea&s it
do%n to %here the income comes from.
53. 'e do not hae to %orry too much about the direct s. indirect method - ;ust care about
%hat ends up on the statement.
5-. Also presents li2uidity matters that are not reflected in balance statement or the income
statement.
60
1. 9han2es in 9ash in H iAerent cate2ories now<
a. *perating 4 +peratin2 9ash Flow X transactions that 2enerate items of re!enue
an e3pense. +nl/ inclues companies opportunities in its primar/ area of 0usiness
(orinar/ course$. *his is the most si2ni>cant aspect of the cash Cow statement.
*his cate2or/ co!ers most of what is si2ni>cant in the ail/ operation of the
0usiness.
i. (nclues<
(a$ ,ales 4 pai in cash or on creit
(0$ '3penses 4 inclues pa/roll, cost of purchases, accounts pa/a0le, an other
uses of cash
(c$ +ther re!enue sources
($ *a3es
(e$ &epreciation on Propert/
(f$ (nterest on 0orrowe mone/
(2$ 9ollections on accounts recei!a0le
(h$ O on returne merchanise
(i$ +peratin2 1ease 0ut )+* a capital lease
(E$ (nterest '3pense on a loan espite the fact that 2ettin2 a loan is part of
>nancin2 acti!ities
(%$ (nterest pai on capital lease espite the fact that capital lease is part of
in!estin2 acti!ities
ii. Mhat oes compan/ earn from operationsS +perations (ncome is not in ,9F, 0ut
rather, 9ash from +perations is. +peratin2 income as use has no relationship
to 9ash from +perations 0ecause 9F+ ta%es interest, ta3es, etc into account,
unli%e operatin2 income

iii. '3ample< )et (ncome plus )on4cash '3penses (amorti5ation, epreciation$ plus
increases in +peratin2 1ia0ilit/ (salaries pa/a0le$ minus increases in +peratin2
:ssets (accounts recei!a0le increase, for e3ample$. @ecei!e other t/pes of
assets rather than cash X reuces cash in income$. 9an tell compan/#s inherent
pro>ta0ilit/.
b. 1n$esting 4 (nclues 0u/in2 or sellin2 a 0uilin2 (althou2h epreciation oes not
show up 0ecause it is a non4cash asset$, 0u/in2 in!entor/, in!estin2 in capital
assets an, usuall/, ma%in2 loans to others. 3nclu%es elements in a transaction of
$urchase / sale for ,eneratin, returns not %irectly relate% to %aily o$erations of the
business.
i. (nclues< Bu/in2 R sellin2 mar%eta0le securities, 0u/in2 an sellin2 lon2 term
assets li%e 0uilin2s, 0u/in2 machiner/, an ma%in2 loans ()+* ='**()= *V'6$
ii. 9apital 1ease is also in!estin2. BB* interest pai on it is an operatin2 acti!it/.
Pre!ents operatin2 cash Cow from 0ein2 as low as with operatin2 lease some
pa/ments are in!estin2 acti!it/
c. 8inancing 4 *ransaction in which compan/ raises capital R 0orrows mone/ (for
e3ample, e0t an equit/ oAerin2s$. *hese are acti!ities that woul t/picall/
in!ol!e an in!estment 0an%er. */pical acti!ities are 0orrowin2, raisin2 capital
throu2h e0t or equit/, compan/ 0u/in2 or sellin2 its own or someone elseQs stoc%.
i. (nclues sellin2 R issuin2 /our own stoc% an 0orrowin2 mone/, :, M'11 :,
Pa/ment of i!iens (which is not part of operations, is not an e3pense or an
income statement e!ent an not li%e interest on a loan$
61
ii. ,pecialt/ Finance (nustr/ pa/s attention to this. ]Per/ popular on pu0lic
mar%et latel/. &ecentrali5ation of 0an%s for 0orrowin2 acti!ities (home equit/ or
creit car loans$. 1oans sol as securities on Mall ,t.^ Bses a22ressi!e
accountin2. +ften co#s were operatin2 0/ issuin2 R sellin2 more stoc% urin2 the
c80s. *hen, inustr/ stanar 0e2an to focus on ,9F. )ow people will thin% of
wa/s to 2et aroun it an ,9F will 0ecome meanin2less.
iii. '3ample< :+1, throu2h a22ressi!e accountin2, counte the amount it too% to
lure customers in an then capitali5e this mar%etin2 e3pense o!er se!eral
/ears. Gou woul not notice that the/ were oin2 this unless /ou loo%e at their
,9F an saw that the/ were onl/ showin2 that the/ ha ne2li2i0le cash from
operations. Moul sa/ mar%etin2 e3pense coul 0e amorti5e, etc. (f /ou i
not loo% at the ,9F, /ou woul ha!e sai that the compan/ ha stron2 net
income.
2. *:F 4 e3ample of operatin2 or >nancin2 e3penseS '!er/ compan/ either has eferre
ta3 lia0ilit/ or eferre ta3 asset.
&eferre *a3 :sset 5,000
*a3 '3pense H0,000
9ash OH5,000
'3ample< )et (ncome X O100,000 at ta3 rate of H0Z so ta3 e3pense is OH0,000.
:mount ue to the (@, OH5,000.
a. *a3 '3pense H0,000
9ash 20,000
&eferre *a3 1ia0 10,000
'3. *a3 &ue (@, X O20,000
6. Preparation an Presentation Bsin2 the &irect 6etho 4 p. 1HH. @eports each account
where there is a chan2e in cash urin2 that perio. 1oo% for cash transactions an report
them.
7. Preparation an Presentation Bsin2 the (nirect 6etho 4 Financin2 an in!estin2 are the
same as irect. ,tarts operatin2 account with net income an onl/ recors transactions
aAectin2 net income. (For e3ample, accrual R eferral, in!estment R epreciation$. Vow to
o it<
1. ,tart with )et (ncome
2. : 0ac% non4cash e3penses
H. ,u0tract increases in current assets (e3amples inclue mar%eta0le securities an :R@$

D. : increases in current lia0ilities
5. : ecreases in current assets
6. ,u0tract ecreases in current lia0ilities X statement of cash Cows.
Me increase :R@ when we sell somethin2 0ut ha!e not /et recei!e cash for it.
)et income inclues sales re!enue. Me ta%e out of :R@ the amount that we recei!e when cash
comes in.
(f :R@ 2oes up, then that is a net amount of re!enue reporte on the income statement for
which we i not recei!e cash.
(f /ou up :RP, /ou ha!e an e3pense on the income statement that /ou ha!e not /et pai for.
*herefore, /ou ha!e to a cash 0ac% to reCect this.
62
(f /ou pa/ on an account, /ou are now more poor, 0ut that fact has not /et appeare on the
income statement 0ecause /ou ha!e not /et ha to pa/ that cash so /ou nee to euct that
amount (of the ecrease$.
(f /ou ha!e a hi2h net income 0ut no sales at all, then there is no cash Cow at all. Gou nee to
0ac% out of net income an/thin2 appearin2 in in!estin2 or >nancin2 acti!ities. (f /ou sell >3e
assets, the pro>t or loss coul 0e part of net income 4 part of in!estin2.
'3ample 4 /ou sell a 0uilin2 for O1,000,000 an 0ou2ht it for O200,000. *a%e out the
O800,000 for in!estin2 4 the O200,000 also is ta%en out an put into the in!estin2 part of the
,9F.
L. 8inancial Statement Analysis H L!y do people loo; at ?nancial statementsQ
C!apter 9
G*A(< to unerstan what ratios are, wh/ the/ are use, what use for an wh/ the/ ha!e
0ecome less important 0ecause of a re!ert 0ac% to the Mil, Mil Mest principles<
*o answer questions a0out the compan/ an often to assess its conition X *o learn a it; one
who %nows it well ma/ chec% preictions mae; ,'9 ma/ chec% for aequate isclosure to pu0lic
in!estors. Financial ratios are a tool use to anal/5e (misuse at times$. '3. (B6, has ratio H<1 X
no meanin2 0ecause nee more facts. People pic% up rules of thum0 li%e 1ia0ilit/ R ,V 'quit/
ration shoul 0e more than 1<1. *his is simpl/ not true an/more 0ecause people on#t want
i!iens li%e the/ use to. &e0t is a much more popular concept now. ,o, a!oi rules of thum0
an inclue conte3t. (ncome an &e0t (front an 0ac%4en$ ratios ma/ 0e use as screenin2
tool 0ut can#t epen on them ri2il/.
'. Balance ,heet @atios
1. Pro?ta+ility "atio tr/in2 to etermine whether /ou are 0eatin2 the rate of return on
a *40ill; what is the rate of return on /our assets. (P@+B1'6 :$
o Pro+lem A< comparin2 0alance sheet items with income statement items.
Vear%ens to the iAerence 0Rw a BR, an an (R, where an (R, is a snapshot.
(ncome stream an e3penses occur o!er an entire /ear an 0alance sheet items
are measure o!er a couple of a/s. *his can create @':1 istortions.
o P"o&(E &A whene!er comparin2 somethin2 at 0oo% !alue, it ma/ ha!e no
relation to current !alue of those assets or equit/. +nl/ tells /ou return of 0oo%
!alue, not current !alue.
T!is is &oo; $alueA i.e. the 0oo% !alue of a corp
2. Pro?t argin "atio want to see how much OO we ma%e, out of e!er/thin2 that we
sell, how much of that o we 2et to %eep 0asicall/, what is the 0an2 for our 0uc%S
$. E@pense "atio tr/ to etermine of what percenta2e of sales, where oes that ollar
2o.
o 1RH; 1RH 1RH rule of law>rms 1RH shoul 2o to person who 2enerate the
0usiness (the partner$; 1RH 2oes to person who i the wor% (associate$; last 1RH
shoul 2o to >rms o!erhea an pro>t.
%. Turn o$er ratiosA how often /ou can turn somethin2 o!er X turno!er ratio; how
compare to inustr/; how compare to /our own e3pectations.
1n$entory TurnHo$er "atio if 9+=, X O200I an a!era2e (n!entor/ was O16; then,
turn4o!er ratio is 5 times. (.e. 5 times urin2 the /ear, /ou sell out e!er/thin2.
o ,hows< )ot carr/in2 a lot of in!entor/. BB*.. if ha!e a P'@G hi2h ratio, it is
pro0a0l/ too 2oo to 0e true an the 9orp is pro0a0l/ carr/in2 too little
in!entor/. *herefore, if carrie more in!entor/, this corp, o!erall, ma/ 0e more
pro>ta0le.
63
Accounts "ecei$a+le TurnHo$er "atio )et sales on account an then how much
was a!era2e accounts recei!a0le. ,ell O16 on account an a!era2e :R@ is O200I. (f
*urn o!er#s are hi2h, this means /ou are 2ettin2 a tremenous return.
o ,V+M,< )ot ha!in2 to chase own so man/ accounts recei!a0le; BB*, if ratio is
too hi2h, pro0a0l/ emonstrates that /ou are not loanin2 out enou2h an not
pursuin2 an a22ressi!e enou2h lenin2 polic/.
o <ustHinHTime 1n$entoryA tr/ to orer in!entor/ Eust4in4time in orer to utili5e,
ha!e smaller retail an warehouse space, an, hopefull/, this eJcienc/ will
ena0le /ou to 0e a more proucti!e operator, e!en thou2h, from time to time,
/ou woul lose out on some sales, 0ecause /ou i not ha!e the in!entor/.
E@. &ell computers< until a few wee%s a2o, /ou coul call an the/ woul
assem0le it ri2ht there (holin2 )+ in!entor/$ sometimes it ships in 1
a/, sometimes 5 a/s where the/ ha!e to re4orer the part.
P"*&(EA when there is a rapil/ 2rowin2 econom/, TB,*in time is
perfect 0ecause /ou ha!e an iea of how much /ou can prouce (all
2oos prouce will 0e purchase immeiatel/$ an therefore, as &ell,
/ou %now how man/ monitors nee to 0e eli!ere each a/. (f wor% at
full capacit/, /ou can preict how much in!entor/ /ou nee a/ to a/.
V+M'P'@, not all economies e3pan at the same rate an /ou 2et<
(ac; o# $isi+ilityA when not wor%in2 at full capacit/, no iea when
that phone4call will come to requirin2 /ou to 2et more in!entor/.
Brotman sa/s this the fall of Tust4in4time (n!entor/ is li%e a Pon5i
,cheme< Mhen econom/ 0rea%s from 0ein2 !er/ 0us/ to )+* 0us/
P'@G quic%l/, this is 2reat for &ell (it oes not use an/ in!entor/$.
But, not 2reat for (ntel, 0ecause the/ are 0uilin2 up from orers
that the/ e3pect from &ell an other computers.; further on up the
chain, this totall/ screws up pple li%e 9ornin2, or Fi0er4optic ma%ers
0ecause, as the poor econom/ tra!els on up the chain, the pple at
the top 2et screwe the most. Mith 0i2 items, suppliers 2et totall/
0urne.
1nternet ) <ustH1nHTime 1n$entory< thou2ht that we woul fail to
0ecome a retail societ/, 0ut, this has not completel/ come to pass.
&. "eturn on A$g Common S!are!olders E0uity HH tr/in2 to see what %in of return
we are 2ettin2 on the net equit/ of the compan/;
8rob/e& 6
8rob/e& #; the net income oes not tell /ou what the return on equit/ is. (f /ou
0u/ stoc% of a compan/, /ou on#t care a0out this ". Gou care a0out the percent
return on G+B@ own equit/. @eturn on equit/ when /ou are ealin2 wR 0oo% !alue
is 0a 0ecause there are so man/ components that etermine what en up on
someone#s 0oo%s
o '.2. if s corp ta%es a maEor hit 0ecause of =oowill (see 0elow$, oes this
reall/ aAect their equit/ an the return /ou are 2ettin2 per equit/ shareS
Vow compare if ha!e 2 ru2 corps an 1 has pai a lot for traemar%s an
therefore has !er/ hi2h le!els of assets.
o I'G<
F. (e$erage "atioA ,hows (assetsRequit/$ how much asset /ou are a0le to 2et per each
ollar of in!este capital. *his is sli2htl/ more meanin2ful than "5 0ecause 0oth
numerator an enominator are in 0oo% !alue. *his 2i!es /ou some assessment of how
2oo or 0a the in!estment will 0e.

64
H. Lor;ing Capital X 9urrent :ssets (e3pect to turn into cash in 1/r$ minus 9urrent
1ia0ilities (e3pect to ha!e to pa/ in 1 /r$. &oesn#t sa/ how much capital neee so not
useful. )ee ratios. Mor%in2 capital X current assets 4 current lia0ilities.
9oncenpt< how much stuA o /ou ha!e that /ou will 0e a0le to turn into cashRhow much
stuA /ou nee to continue oin2 0usiness.
:ci *est X SS
T. Cas! 8lo. 8rom *perations to Current (ia+ilities "atioA this is more meanin2ful
than immeiatel/ 0elow.
Q. Current "atio X 9urrent :sset (ie cash wRin one /ear$ R 9urrent 1ia0ilit/(ie ue with in
one /ear$ - 1.65 ratio means 165Z of its current lia0ilities in current assets. Mhat#s
wron2 with this when tr/in2 to etermine operatin2 capitalS @atio remains constant.
Be careful onl/ to pull current. +ptimal X 2. 9urrent @atio X current assets R current
lia0ilities. 6ore of a liquiation >2ure worst case scenario. Vow are we 2oin2 to pa/
for our e0ts if the/ come ue.
i. ,napshot 4 )ot reCecti!e of Cuctuations (Per/ rou2h$.
ii. 9o#s can Kwinow ressL their 0alance sheets to efer losses to the ne3t >scal /ear.
(Tapan$
iii. 9ash can 0e committe an not show up with lia0ilities. (lia0 ue Tan. 2 an assets
&ue &ec. 2$
$. Ouic; ratio X 9urrent :ssets ]in!entor/ ; eferre income ta3es ; +thers^ R 9urrent
1ia0ilities. :ci test e#clu%e inventory an% $re$ai% assets. Bse Y@ as >lterin2
e!ice. (f ratio 10<1 focus on other area 0ecause loo%s o%. ()ee to %now somethin2
a0out inustr/$. 1oo%in2 for minimum ratio of . an% $robably aroun% <-
%. 1n$entory Turno$er "atio4 helpful. Pro0 N< 1oo% at " times in!entor/ turne o!er in 3
amount of time. Formula< 9urrent Gear#s 9+=, R ]Be2innin2 (n!entor/ ; 'nin2
(n!entor/^ R 2. @ule is usuall/ that if H or 0etter timesR/r 2oo, if less then 0a. BB*, (f
hi2h pro>t mar2in, coul 0e o% to ha!e low turno!er (Eewelr/, e2$ 0ut if low pro>t
mar2in nee hi2h in! turno!er (@3 e2$. Mhat#s funamental pro0lem with operatin2
2ross mar2inS *urno!er can 0e lt, e2, in retail if 2RH one in 1 season (in!entor/ spurts$
an oesn#t tell what real in!entor/ is. 9an create appearance of turno!er if on#t use
true wei2hte a!era2e. :lso an/time /ou mi3 0.s an i.s., /ou#re mi3in2 thin2s not the
same so 2et misinformation.
=ross Pro>t mar2in X sales minus 9+=,
&. Accounts "ecei$a+le "atio 4 For amount of sales mae on account, how quic%l/ o
/ou collectS (n eAect, how often o /ou turn o!er accounts recei!a0leS 9reit ,ales R
]Be2innin2 :@ ; 'nin2 :R@^ R 2 X " a/s outstanin2 (on a!era2e$ if i!ie into
H65, 2et a!era2e turno!er of :@. Inow ue ate of :@. Flaws< Va!e to assume all
creit sales 0ecause no info so lt utilit/ of ratio. Mant to %now if creit not popular
0ecause otherwise wh/ ha!e it. (mportant to %now cashRcreit mi3. 9an iAer e!en
wRin same inustr/.
F. Accounts Paya+le "atio ' GET TK1SYY
H. :e+t I E0uity "atio 4 2 most wiel/ use (ne3t to price R earnin2s$. 6eans 1 of H
thin2s<
a# total e0t (lia0ilit/$ R 0/ total ,V equit/. (p. 156$
65
b# 1* e0t to equities (total lia0ilit/ minus current lia0ilit/ i!ie 0/ equities$. &eals
with capitali5ation (more theoreticall/ correct$. 9an 0e manipulate 0/
characteri5in2 ,* lia0ilit/ as 1* lia0ilit/. People li%e to see 1<1 historicall/, ]i.e. o
not want to see a corp that ha more e0t than equit/^ 0ut now 2<1 o%, ha!e to o
research. (D<1 t/pical 0ecause hi2hl/ le!era2e more accepta0le.$
c# T!is is use#ulA 0ecause leners li%e to ma%e4sure that 0orrowers ha!e a sta%e
in somethin2; if /ou ha!e somethin2 to >2ht for in equit/. 1eners lo!e to see
equit/ 0ehin them
d# 9apitali5ation @atio 4 *otal 1ia0ilit/ R (*otal 1ia0 ; ,V equit/$. 2<1 stanar. :lso
calle &e0tR9apital ratio.
H. Times 1nterest EarnedA as% what out net income is what is our total Cow an as%
how man/ times we can co!er that. ,omeone can 2i!e /ou a loan; 1ener wants to
ma%e sure that /ou ha!e enou2h cash4Cow from earnin2s that /ou are 20Z cushione
so that if /our earnin2s 2et screwe for a certain perio, /ou ma/ still pa/ for this.
1<1.2 ratio.
a- 1n !ousing mar;et5 lenders are more aggressi$e.
b- Jac7*en% ratio ! *otal e0t ,er!iceR=ross income not more than H6Z 44 D0Z
6. 3ncome 6tatement )atios
1. Gross *perating Pro?t argin< =ross Pro>t on ,ales R *otal net sales. *ren an
!ariation anal/sis important here.
2. Pro?t argin< )+*' *V(, (, B@+*6:)Q, M:G< (,ales 4 9+=,$ R ,ales X =ross Pro>t
6ar2in. Brotman consiers the followin2 terms to 0e interchan2ea0le< 2ross pro>t
mar2in, pro>t mar2in, an 2ross mar2in.
$. 1nterest Co$erage "atio 4 )ot reall/ a co!era2e ratio, similar to e0t R equit/.
'arnin2s R interest pa/ment o0li2ations. 9an also 0e shown as 'B(*&: R (nterest
'3pense. ('B(*&: X earnin2s (net income$ 0efore interest, ta3es, epreciation, an
amorti5ation.$ 6easures how much compan/ has to pa/ in interest (" 3#s interest
o0li2ation co!ere 0/ earnin2s$. )et (ncome R (nterest '3pense 0ut net income
oesn#t tell an/thin2 a0out cash. 6uch more useful to 0an%s is 9ash &e0t 9o!era2e
@atio (or, &e0t ,er!ice 9o!era2e @atio< amount of loan R F6P of securin2 collateral$.
@atio X 9ash Cow of 0orrowin2 entit/ (from operations$Re0t ser!ice pa/ments
(principle an interest$.
%. Price to Earnings "atio X 6ar%et !alue of a share of compan/#s stoc% R 'arnin2s per
share. Pu0lishe P' is actual " an Forwar P' is anal/st#s proEection (useful in
comparin2 co#s$. ,h 0e 0ase on prior /ear. Earnings per s!are is wiel/ use ratio
itself. 'P, X net income R " shares outstanin2. Mhen we calculate 'P,, we ta%e into
account the options, etc for a full/ ilute 'P,. =enerall/, onl/ assume options con!ert
into common stoc% if it#s li%el/ (wRin 10Z$ 4 follows principle of conser!atism.
(naccurate theor/ re< 'P, is to require Za2e return in!erse of 'P, ratio4 onl/ has use if
compare wRin inustr/ an 0ase oA prior /r.
2ry to com$are P" ratio of . cor$ to another or cor$ to itself@ but@ we must 'uestion
how reliable this is currently
&. "eturn on E0uity X )et income (current /ear$ R 'quit/ (en prior /ear$.
F. "eturn on Assets X )et income R :ssets.
66
H. Ouality o# 1ncome "atio I Ouality o# Earnings X 9ash Flow from +perations R
'B(*&:
7. 9ash Flow @atios 4
1. 9ash (nterest 9o!era2e ratio< 9ash Flow Pro!ie 0/ +peratin2 :cti!ities R *otal (nterest
'3pense.
2. 9ash &e0t 9o!era2e @atio< 9ash from +perations 4 9ash pai in i!iens to ,V.
$. 9ash &i!ien 9o!era2e ratio< 9ash Flow pro!ie 0/ +peratin2 :cti!ities R 9ash
&i!iens.
%. Yualit/ of (ncome @atio< 9ash Flow Pro!ie 0/ +peratin2 :cti!ities R +peratin2 (ncome.
&. 9ash Cow per share X 9ash R +utstanin2 ,hares.
F. 9ash @eturn on :ssets X )et (ncrease (&ecrease$ in 9ash (9urrent Perio$ R *otal :ssets
(Prior Perio$.
LI. Accounting #or &usiness Com+inations 6 Auditing 6 t!e (a.yer9s
"oleA C!pt 1,A
:ccountin2 for an acquisition was either in Purchase Form of Poolin2 Form
Purc!ase simple >2ure out what /ou are pa/in2 an then >2 out what /ou are
0u/in2.
o ar; to ar;et ta%e all assets of unerl/in2 9orp an !alue them at F6P (all
semester 0ecause of the 2oin2 conern principle, we ha!e not ta%en F6P$ here,
/ou a all assets up an !alue them at F6P
Paluations for equipment, (P, etc.
o :&& F6P of assets acquire lia0ilities assume X )'* F6P of assets acquire.
*o e3tent that purchase price e3cee )'* F6P of assets acquire, this is
=++&M(11
Good.ill the e3cess of the purchase price o!er the )'* F6P of assets
acquire in a 0usiness com0ination usin2 the purchase metho of
accountin2.
*his is a compromise of cost accounting alwa/s accountin2 for asset at
historic cost; with G*1JG C*JCE"J principle all assets are require as
2oin2 concern an e3pene in some wa/ now, 2oowill is a permanent
asset unless it has 0een impaire. Before, 0/ not accountin2 for 2oowill
at all, we were !iolatin2 0oth of these principles 0ecause 2oowill woul
not appear on the 0alance sheet +@ the income statement.
)ote< this is a technical e>nition. (t oes not ha!e to o with the
reputation of the corp, the s/ner2ies, etc.
(f /ou are the acquirer, /ou woul rather put K=oowillL on 0alance
sheet rather than K:mount 0/ which we +!erpa/e for the :ssetL
o Mhen /ou acquire assets, e!er/ asset is, in eAect, a pre4pai e3pense
6achiner/ must 0e epreciate
(ntan2i0les such as 2oowill must 0e amorti5e o!er time.
*his was reall/ a0use in the , W 1 crisis in the 1N80#s, where,
essentiall/ if 0u/ 1on2 term loans recei!e an 0u/ at a time
where interest rates much hi2her than price at issue. :s interest
2oes up, price 2oes own, an therefore, /ou woul 0e 0u/in2
those assets at a :iscount. 6ust ta%e this pro>t into income o!er4
time as aitional income. Mhat man/ pple i was, after this
0usiness com0ination, the/ woul ta%e this 2oowill, the/ woul
pa/ O75I a0o!e the price an, the/ woul write oA the =oowill
o!er D0 /ears.
67
o =oowill '3pense O7500 (non4cash e3pense$
=oowill use O7500
*his lea to a chan2e in how to amorit5e 2oowill cannot 0e
amorti5e less than the 1',,'@ of D0 /ears or the a!era2e useful
life of the 2oowill.
o '3. (f purchase (P (patents an traemar%s$ an a!2 will last
for 15 /ears, cannot amorti5e for less than that 15 /ears.
o M:6 (wei2hte a!era2e maturit/$RMei2hte :!2 9oupon is
wei2hte a!era2e interest on the assets
o 9annot 0orrow a2ainst =oowill an/more.
'3. C1SC* and Serum (9(,9+ acquire ,'@B6$ for O7B this was : 1+*
of 2oowill. (f ha!e to amorit5e this o!er e!en D0 /ears, this are VB='
char2es a2ainst earnin2s. 9orps i not want to o this, so, the/ lo00ie
an sai that in certain situations, this purchase metho is 0a, an
instea, /ou ha!e amer2er of 2 equals. *herefore, put all assets an all
lia0ilities of 0oth corps, an put on 0alance sheet of sur!i!in2 corp at
B++I P:1B'; no mar% to mar%et an )+ 2oowill.
1$ not ha!e to amorit5e 2oowill o!er time
2$ (f other 9orp has appreciate assets (a 0uilin2, for e3.$, o not
ha!e to write4oA assets that ha!e appreciate in !alue an, 0oo%
!alue here is 6B9V smaller than F6P.
*hese eals were a0use such that ,erum ha onl/ O25I in cash 0ut pai
O7B for it. 9(,9+#s mar%et share was worth 6B9V more than this, an,
0ecause it was allowe to 0e pooled, the interests were poole an
9(,9+ 2ot to a!oi the pro0lem of 2oowill an pool the assets.
9(,9+ pro0a0l/ 0ou2ht ,'@B6 0ecause the latter ha assem0le
an increi0le team of en2ineers in the *elecom sector. 9(,9+ i
not pa/ cash for this, the/ onl/ pai 2Z of their paper. *herefore,
the/ 2a!e 0ac% O1.60 of the O70 that /our stoc% has 2one up o!er
the /ears, this is not such a 0a eal
o *',*, so that ma/ use P++1()= 6'*V+&<
1$ (most imp$ )+ cash purchases, nee at least N0Z !otin2 ri2hts stoc%
for !otin2 ri2hts stoc%
o Poolin2 oes not accuratel/ reCect what happene not show asset !alue of
what happene on the 0oo%s. &istort the assets. Gou :@' actuall/ 0u/in2
another corp an therefore, /ou must show costs at historic cost. *herefore,
pple wante to 2et ri of poolin2 metho.
*ech 9orps were P'@G a2ainst this 0ecause the/ i not want to ta%e
char2es a2ainst earnin2. BB*\\\
,()9' 7R01, there is no such thin2 as poolin2 of interests; e!er/ 0usiness com0o must
0e accounte for as a PB@9V:,' of ()*'@',*,.
o (n return, /ou )+ 1+)='@ ha!e to s/stematicall/ write oA =oowill as a cost.
Gou Eust ha!e to, from time to time, etermine whether there has 0een a
Kpermanent impairmentL of that 2oowill. Brot has no iea what the hell
permanent impairment means. ]this was the concession to the *ech corps^
T!is !as created an analytic analomyA '3. P'P,( 0ou2ht Yua%er +ats in orer to
2et =atorae name 0ran this new theor/ means that if =atorae has 0een oin2
well, P'P,( nee no account for the cost, a0o!e 0oo% !alue, of o0tainin2 Yua%er +ats.
(t is not char2e a2ainst earnin2 on the 0oo%s
o 1an ne!er epreciates as wellU0ecause, 0/ e>nition, it sta/s as lan an the/
are not ma%in2 an/ more of it. (t is consiere 1 supreme asset, cannot create it.
68
o Brot< this ma/ mean that we ma/ not reall/ %now what >nancial statements
mean
(t will help certain companies who ha!e 0een amorti5in2 2oowill, the/ no
lon2er ha!e to o this.
Preition< Brot feels that corps who must ta%e the K permanent
impairmentL cost an cate2ori5in2 it as an 'F*@:+@&():@G (*'6 one
that is not reCecte in )et (ncome. 9orps who en up oin2 this will 0e
cate2ori5in2 as a 14time char2e an therefore, it will not appear on
income statement.
'3traorinar/ (tem &e>nition< Ksomethin2 that is 0oth unusual an
infre'uent.L
o '3. for corps that are in Vurricane 5ones, /ou cannot call this
e3traorinar/ 0ecause it is seen as relati!el/ common.
o 9ontinuin2 Yuestion< whether a permanent impairment of
=oowill can e consiere an '3traorinar/ (tem
*his epens on whether /ou are a corp that acquires
a lot of other corps or one that has ne!er acquire a
lot of corps.
T!ese am+iguous terms t!reaten t!e $ery principles o# "elia+ility and
Consistency in AccountingA :t the en of the a/, the more of these items, that the
timin2 an amt can 0e su0Eecti!el/ etermine 0/ the 9orp, wRin the realm of =::P,
wRo cheatin2, it 0ecomes harer to compare an corp to itself o!er time (consistenc/$
an to others (relia0ilit/$.
'. 6ethos 9ompare an (llustrate 4 methos seem insi2ni>cant 0ut important (e.2., 1(F+
!. F(F+, epreciation methos, leases, etc$. 9an 0e enormous iAerences in results R
presentation
1. )othin2 is more important than comparin2 the iAerence 0Rw Purchase 6etho an
Poolin2 6etho of :ccountin2. +!er past 15 /ears, how to account for 0usiness
com0inations has 0ecome reall/ important.
2. Business 9om0inations
c- : ; B : (this is usuall/ what happens$
%- : ; B 9
$. Factors< 'conomic transformation where tech chan2es aAect proucti!it/ (e>ne as
amount of prouction in >3e ollar amount of la0or$; Political aEustment perio
(ere2ulation, mer2ers 4 e.2., interstate 0an%in2$; chan2es in worlwie econom/ X
6aEor tren towar consoliation. (ncreasin2l/ important is how to account 0ecause
it#s how /ou >2ure out what somethin2 is worth (not most important 0ecause !aluation,
not accountin2 focus unless on#t qualif/ for poolin2$<
i. Pooling et!od 4 !er/ few companies acquire other than as purchase. ,ee p. 216. :lmost
all mer2ers where pu0lic companies tr/ to use poolin2. Poolin2 a!ois ha!in2 char2es to
earnin2s (a!anta2e$. Focuses more on income statements. *his is an accreti!e
transaction. *his metho allows increases in earnin2s, not 0urenin2 of earnin2s. 2 t/pes
0usiness com0ination<
"a# : 0u/s B (economicall/ e!en if not le2all/$.
"b# 6er2er 4 true where 2 corps 0ecome one. ('3. =' an @9:. @eali5e that shoul account
for it iAerentl/ 0ecause not purchase$.
'3. Poolin2< Price oesn#t matter 0ecause it is not reCecte in the 0oo%s here. Vi2her net
income than purchase metho. (Because no increase for epreciation R amorti5ation e3pense,
for e3ample.$ @ecore assets an lia0ilities of each are poole at historical 0oo% !alue.
F6P X 175
69
Bu/er< :ssets 100
1ia0ilities 70
,V 'quit/ H0
,eller< :ssets 100
1ia0ilities 70
,R' H0
ii. Mhen ,'9 an accountants reali5e poolin2 ha 0ecome so hi2hl/ preferre, the/ came up
with criteria which must 0e present in orer to account for a 0usiness com0ination with the
poolin2 metho. &esi2ne to ma%e sure it#s 2 companies com0inin2<
"a# has to 0e complete within 1 /ear.
"b# has to 0e at least N0Z of acquire compan/
"c# cannot ha!e an/ chan2es in equit/ 4 (6P+@*:)* 4 neither compan/ coul ha!e 0een
another compan/Qs su0siiar/ urin2 the past 2 /ears.
"d# cannot reacquire e3istin2 shares 4 Poison Pill 4 compan/ 0uils in tri22er shares so auto
reacquire shares to pre!ent poolin2 in hostile ta%eo!er. :lso, 9ash ,ettle ,toc% +ptions
4 let people tener ol shares for new shares. 9lears a poolin2.
"e# !otin2 ri2hts must 0e maintaine
"f# )+ 9:,V 4 cannot pa/ for the com0ination in cash 4 6ost important rule (pri!ate co#s
want cash so on#t o poolin2$.
"g# )o contin2ent consieration
"h# )o plan for liquiation or epreciation
"i# )o reacquirin2 of shares issue in com0ination
"O# no other >nancial arran2ements (2uarant/ of loans secure 0/ stoc% issue, e.2.,
0ecause it ne2ates e3chan2e of equit/ securities$.
"8# autonom/
"l# inepenence
iii. Purc!ase et!od H :ssets, e.2. 'ntit/ acquire is no lon2er a 2oin2 concern.
Va!e to o a mar7 to mar7et (mar% assets up from 0oo% to mar%et !alue$.
:iUerence +et.een amount paid and #air mar;et $alue ' good.ill which is
treate as an asset an which will 0e amorti=ed. ((f usin2 purchase metho an
pa/ more than net !alue of assets in an arms len2th transaction, s/ner2ies, etc$.
=oowill nees to 0e amorti5e o!er time. 9annot e3cee e3pecte economic life
of assets attri0uta0le to 2oowill an cannot 0e more than D0 /ears. (, W 1 4 man/
0elie!e =::P encoura2e o!erpa/in2 for , W1 0ecause pa/in2 for soun where
unsoun X future e3pense$. For a lon2 time, people focuse on 0alance sheet an
li%e purchase metho. ,'9 sai no, if poolin2 is what /ou#re oin2, nee to use
that metho. Preferences chan2e. Pro0lems with purchase metho< increases
!alue of asset sie; we onQt want inCate intan2i0les (i.e. traemar%s li%e 9o%e$;
ha!e to amorti5e thin2s li%e 2oowill; ta%es awa/ from income; 2oowill, to a certain
e3tent, shows how much /ou o!erpai.
'3. Purchase< Price O225
Bu/er< :ssets 100
1ia0ilities 70
,R' H0
,eller<
:ssets 175
=oowill 50
1ia0ilities 70
,R' 155
70
55. @oe assets oer at F@= and price e<cess %ill be good%ill. AmortiBation and depreciation
F ne% e<p. Iigher total assets because F@=. Iigher e<penses. Ac2uiring entity records
ac2uired entity1s assets at F@=.
i/. Earnings Accreti$e 4 (ncreases in earnin2sRshare on 2oin2 forwar 0asis. People
want to %now if this will happen when com0ine. (f /ou account for somethin2 as a
purchase, /ou ha!e a lot of hits in the future. Gou on#t ha!e to uner poolin2.
'3. Before< O5000R1000 shares outstanin2 XO5Rshare X 'P,
:fter< O8D00R1200 X O7Rshare
O8D00 earnin2s reuce 0/ epreciation an amorti5ation so uner purchase metho
earnin2s can ne!er 0e as accrete as uner poolin2.
ii. Poolin2 is hu2e focus. +ften eal40rea%er. ,hows how powerful accountin2 is.
,ellin2 one compan/ afterwar can pre!ent poolin2. : lot of istortions happen
here.
iii. Vow use of accountin2 can cause economic pro0lems< ,W1#s re2ulate hea!il/
historicall/. (n the late 1N70Qs, there was a massi!e rise in interest rates followin2 a
rise in inCation. *he ,W1Qs were in trou0le 0ecause the/ recei!e less return on
their assets ue to their 2o!ernmentall/ set interest rates 0ein2 0elow national
rates. (n the earl/ 1N80Qs, ,W1Qs were ere2ulate so that the/ coul compete with
re2ular 0an%s. 2 0a thin2s then happene< ,W1Qs i not %now how to ma%e the
same %in of loans an re2ulators %now nothin2 a0out 0an% loans. ,W1#s then
mae eAorts to attract customers. )ot pro>ta0le institutions 0ecause e3penses
e3ceee re!enues. :ppro!e loans for low interest rates so lia0ilities hi2her rate
than assets. , W 1#s amorti5e 2oowill o!er perio of time 0e/on life of assets
an each /ear showe si2ns of pro>t. Vu2e 0onuses ta%en 0/ e3ecuti!es. &in#t
care a0out cash. Moul o cra5/ eals for income. 9har2e hu2e fees that came
out of loan. Moul acct for these so a0le to show 2oo creit 0ut usin2 /our mone/.
Moul clean up future income statements. 9V:)='< now cannot amorti5e 2oowill
0e/on life of assets (:s a result of ,W1$. ,'9 will re!iew if /ou >le to amorti5e o!er
lon2 perio of time. +ne accountin2 >rm went 0an%rupt an another lost license in
9:.
Balance ,heet of ,W1<
:sset O1000 (10 /ear loan with 5Z interest per /ear$
1ia0ilit/ O1000 (H0 /ear 0on with NZ interest per /ear.
*his create a cash Cow pro0lem 0ecause the/ neee to pa/ our more than
the/ were ta%in2 in. ]:ssume a 2oin2 interest rate of NZ.^ *herefore, the/
essentiall/ create a shell into which the ol ,W1 woul mer2e. *he/ woul
o this usin2 the purchase metho.
)ew ,W1 Balance ,heet<
1oan D00
=oowill 600
Bons 1000
)ow, one /ear later< collect O50 on loan an write up loan 0/ 60 (O60 per /ear to
2et to O1000$ an ha!e interest re!enue of 110
9ash 50
1oan 60
(nterest @e!enue 110
71
(nterest '3pense (0ons$ N0
9ash N0
:morti5ation '3pense 15
=oowill 15
)ow, ,W1 is turnin2 a pro>t< 1104105X5. )ow, 0an% ma%es new, ris%/ loans to
co!er the mone/ it will nee to ha!e when it can no lon2er amorti5e 2oowill. *his
is where the crash 0e2an.
i/. D (mporatant thin2s 1earne<
"a# 1ac% of response of accountants to chan2in2 e!ents.
"b# lac% of unerstanin2 0/ people who use accountin2 proceures
"c# si2ni>cant impact where 2et arti>cial factor
"d# 9omplicit/ of , W1s an tenenc/ of accountants to hie 0ehin =::P.
:ccountin2 profession cannot 0e responsi!e enou2h. 9ommunication an info
much more wiel/ a!aila0le now an people are more aware. 1aw/ers can#t
hie li%e accts.
LII. Ialuation 2echni'ues:
'. Purchase 6etho 4 6a/ isre2ar le2al >ctionsRrealities. 9an ha!e this where entit/
continues to e3ist (owne 0/ another$ 0ut onl/ in le2al R economic sense. @etaine
'arnin2s 4 onl/ ma%es sense in terms of 2oin2 concern assumption.
6. :ppraise !alueRBoo% !alue (/ou shoul not fa!or this, tells nothin2 a0out current !alue$.
6er2er usin2 purchase metho arms len2th transaction, at this point entit/ woul equal
mar%et !alue$.
7. Vow o people use =::P to !alue a pu0lic compan/S P' ratio4 ta%e full/ ilute 'P, (e.2.
on )G,' 2D<1X!er/ hi2h historicall/$. P' 2rowth 4 mar%et multiples are alwa/s up when
interest rates are own. ,toc%s are attracti!e 0ecause rate or return is compara0le to cash
return on 0ons. :lso, of three >nancial statements, income stmt t/picall/ use to come
up with !alue of compan/ (0alance sheet 2i!es onl/ 0oo% !alue an ,9F oesn#t come up
with total$.
?. Pri!ate 9o#s are totall/ iAerent in !aluation. 'state ta3es are !er/ hi2h an concern here
is low 0asis so !alue 0i5 for this purpose. Focus on 'B(*&: (or operatin2 income$ which
represents cleanest startin2 point 0ecause focus on pro>ta0ilit/. (f, e2, thin% people
eman 8Z rate of return, 12.50 is result. 9apitali5e earnin2s 4 i!ie earnin2s 0/ esire
rate of return. *he lower the cap rate, the hi2her the price. 1ower the interest rate, hi2her
the price. (s there an/ iscount on comp !alue 0ecause of lac% of controlS Bene>ts of
=::P 4 s/stem of accountin2 for e!ents that all unerstan (preicta0ilit/ an
consistenc/$; 6eans /ou unerstan the 0asis, historic cost, an allows /ou to compare it
to other compara0le inustries; Mill 2i!e 0oo% !alue.
E. Mith 0an%s 4 people care a0out 0oo% !alue. Ban% sells for hi2her than 0oo% !alue
(multiple li%e D3$.
>. :uitor#s @ole 4 ma%e sure >nancial statements prepare in accorance with =::P.
Positi!e con>rmation 4 ma%es some0o/ o somethin2. )e2ati!e 9on>rmation 4 on#t
ha!e to o an/thin2.
72
M. 1aw/er#s @ole 4 auitors sen letters to law/ers Ktell us a0out an/ penin2 lia0ilities of the
coL an law/ers worr/ a0out whether answer will 0e pu0lic, accountant R client pri!ile2e
(epens on state an 2enerall/ not so estro/s attorne/4client pri!ile2e$, an tr/in2 to 0e
e!asi!e (ne!er sa/ Kpro0a0leL$. *ension 0Rw auitors an accts. :cct approachin2 thin2s
from !er/ conser!ati!e perspecti!e 0ut 0usiness law/er is not. 1aw/er W accountants
shoul 2et auitor a!ice ahea of time 0ecause law/er has e3pansi!e !iew while
accountant has narrow !iew.
LIII. 5otes (Cast 1lass .OOO:
:. Purc!ase et!od< assumes, re2arless of the actual form of the transaction, that the
transaction is one where one compan/ is the acquirer an the other compan/ is 0ein2
acquire. *he acquirerQs >nancial statements will 0e the sur!i!in2 ones. Bner this
metho, assets are !alue at their F:(@ 6:@I'* P:1B' (F6P$ an lia0ilities are at F6P.
Purchase metho requires increasin2 !alues on 0oo%s to fair mar%et !alue at the time of
the com0ination. Gou must also amorti5e these amounts. *his is wh/ companies o not
li%e this metho.
B. Good.ill X amount paid H 8D. *his is strictl/ a technical term. 9ompanies o not li%e
2oowill 0ecause it is an illustration of how much /ou o!erpai. Gou also ha!e to amorti5e
that amount o!er time, which is not esira0le.
9. Pooling et!od< uses the 0oo%s of 0oth entities to ma%e a new set of com0ine 0oo%s.
&. '3ample< 9o%e an Pepsi are to com0ine. 'ach has their traemar%e name on the 0oo%s
for O100, thou2h the/ each ha!e a !alue of O10,000,000.
1. Purchase 6etho< assume 9o%eQs 0oo%s will sur!i!e. *he Pepsi *6
2oes on the 0oo%s at O10,000,000 total *6 on 0oo%s will 0e O10,000,100. *hen the
compan/ must eal with this e3pense o!er time.
2. Poolin2 6etho< *6 !alue on 0oo%s will 0e O200.
'. ,ince e!er/one wants poolin2, there are strict requirements that must 0e met in orer to
qualif/ for poolin2. *he 2 most si2ni>cant are that (1$ there was a stoc%4for4stoc% transfer
an )+* a cash transfer; an (2$ a0sence of plans to 0rea% up the compan/.

F. 'mplo/ment a2reements ma/ also interfere with the a0ilit/ to qualif/ for poolin2.
*herefore, toa/, man/ emplo/ment a2reements sa/ that if a pro!ision woul pre!ent
poolin2, that pro!ision will 0ecome !oi. *his places the a0ilit/ to qualif/ for poolin2
a0o!e the emplo/ment contract
=. Poolin2< all num0ers are liste at historic cost, on own epreciation scheules, with no
reCection on the 0alance sheet of what the compan/ actuall/ pai for them in the mer2er
transaction. With $oolin,@ you never char,e a,ainst earnin,s the amount you $ai% for
ac'uirin, the other com$any.
73
V. +B@ ,W1 '3ample< create a mer2er so that /ou create the asset of 2oowill create
arti>cial pro>ts ma%e the ,W1 loo% 0etter than the true state of its >nancial health.
=oowill 560
1oan @ecei!a0le 1000
&iscount of 1R@ 560
)ote Pa/a0le 1000
)e3t /ear< amorti5e 2oowill o!er D0 /ears an loan o!er 20 /ears
9ash 60
(nterest @e!enue 60
(nterest '3pense N0
9ash N0
:morti5ation e3pense 11
=oowill 11
&iscount 22
(nterest @e!enue 22
*+*:1,<
@e!enues X 80 ; 22 X 102
'3penses X N0 ; 11 X 101
,o, we en up with re!enues \ e3penses an we ha!e create falsel/ hi2h re!enues 0/
amorti5in2 the 2oowill o!er a lon2er perio than the loan. *his is a temporar/ solution.
Mhile oin2 this to ma%e the 0oo%s loo% o% in the short term, the ,W1Qs went out an mae
ris%/ loans, hopin2 to ta%e in enou2h mone/ so that when this scheme was no lon2er
possi0le, the/ woul actuall/ 0e ta%in2 in enou2h mone/ to sta/ aCoat. Vowe!er, this i
not wor% when loans 0ecame uncollecta0le.
74