Introduction to Accounting - 1st Edition - Anthony Webster

INTRODUCTION TO ACCOUNTING

ANTHONY WEBSTER1ST EDITION

Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

INTRODUCTION TO ACCOUNTING

1ST EDITION

ANTHONY WEBSTER

Copyright © 2013, Applied Finance, LLC.ISBN 978-1-6289-0809-1


CONTENTS

1. Introduction – Why Accounting is so Great2. Accounting Basics3. The Balance Sheet4. Recording Accounting Events5. Case Study: The Collapse of Fannie Mae6. Income, Owners’ Equity and Cash Flow Statements7. Entity Typology, Inventory and Cost of Goods Sold8. SGA, Depreciation Revisited and Taxes9. Case Study: Taxation of Investment Managers and Athletes10. Cash Accounting11. Comprehensive Accounting Example12. Sources and Uses of Cash and the Indirect Cash Flow Statement13. Ratio Analysis I: Ratios Derived from Financial Statements14. Ratio Analysis II: Ratios Derived from Market Data

and Financial Statements15. Afterword

About the Author


WHY ACCOUNTING IS SO GREAT

CHAPTER 1


INTRODUCTION

WHY LEARN ABOUT ACCOUNTING?Knowledge of accounting and finance provides a helpful framework for viewing andunderstanding many aspects of modern life. An understanding of both subjects is needed tosolve many problems faced by engineers, managers, entrepreneurs, and investors.

Accounting in particular is, as Warren Buffett has said, the language of finance. This makes it aprerequisite for comprehending most financial topics, and a useful subject on its own (as we willsee in this chapter). For these reasons, learning accounting is a good first step toward everythingfrom making personal investment decisions to optimizing a manufacturing plant's efficiency tobecoming Chief Financial Officer (CFO) at a multi-billion dollar technology company.

WHY USE THIS BOOK TO HELP YOU LEARN

ACCOUNTING?Aside from my vain and baseless hope that this text would prove as compelling and lucrative as aHarry Potter novel, I wrote it first and foremost to help students in my Introduction toAccounting and Finance course at Columbia University master a subject that is very differentfrom those encountered in their other classes. As I reviewed texts for the course, I found manythat were helpful but seemed needlessly obfuscated, wordy, or non-topical1. I’ve tried to avoidthese pitfalls in this book by using several straightforward techniques:

· Keeping it short and topical.Understanding that time is a precious resource and accounting is on few people’s “most funI’ve had in years” lists, I try to impart the basics of accounting as tersely andstraightforwardly as possible. In this sense I attempt to follow the spirit of a math orengineering text, favoring directness and pithiness to long introductions and many-paragraphed explanations. On the other hand, unlike many science-oriented texts, this bookaims to keep readers engaged through the liberal use of topical, real-world examples drawnfrom my financial consulting practice and the financial press.

· Explaining accounting’s typology and its relation to business typology.Most introductory accounting texts assume that all entities are of the industrial type, featuringinventory and lots of sales-generating property, plant and equipment (PPE), but with norevenue-creating intangible assets (such as loans originated), and no revenue generated fromnon-accounting assets (such as human capital). This is nuts in an economy where non-industrial entities contribute more than 35% to GDP2.

1. There are of course exceptions to this, including for example the excellent Core Concepts of Accounting text byBreitner and Anthony. This book is a bit too basic for my courses’ needs.2. Bureau of Economic Analysis: http://www.bea.gov/industry/gdpbyind_data.htm

CHAPTER#–TITLE PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

In this book, I divide for-profit entities into three business types – Service (or Consulting),Industrial, and Financial – and compare and contrast their micro-economic events, associatedaccounting transactions, and the peculiarities of their financial reports. By first introducingService or Consulting firms, I postpone the discussion of inventory (and Industrial entities ingeneral) until the basics of accrual accounting, accounting’s vocabulary and depreciation aremastered.

· Assuming a computerized worldI assume throughout the book, as shown by widely-utilized programs such as QuickBooksand Peachtree, that basic accounting is well modeled as a rule-based system of recording andreporting an entity’s economic events. Accordingly, I’ve eschewed some by-hand basedlearning tools – like T Accounts – in favor of more spreadsheet and database-oriented aids,such as Transaction Tables (as defined in Chapter 2).

This said, all this text’s learning aides and accounting examples are established so thatreaders may work by-hand. My objective is not to have readers practice exclusively or evenprimarily on a computer. It is rather to teach them certain aspects of accounting in thecomputerized framework (IE: a spreadsheet and database framework) that has beencommonplace since the 1990s.

· Using a bit more algebra than usual.All accounting texts of course feature reams of arithmetic, but the simple algebra underlyingmany accounting concepts is often left unpresented. Where appropriate, this text usesalgebra to help develop some concepts and financial statements. For example, I’vedeveloped the indirect Cash Flow Statement from the fundamental accounting equation (inChange in Assets = Change in Liabilities + Change in Equity form) by expanding terms,applying appropriate rules and algebraically rearranging quantities. Hopefully, this approachallows readers to understand where the indirect statement comes from and why it gives thesame result as the direct method statement.

· Personalizing the text’s voiceUnlike most textbooks on any subject, this book is largely written in the first person. It isalso sprinkled throughout with real-world commentary and anecdotes3 based on my daily useof accounting and finance to assess the strength of potential investments for my firm’sclients.

Hopefully these techniques make this textbook more accessible and interesting than it might beotherwise. If not, the good news for disaffected readers is that countless alternative accountingtexts are available to choose from.

Bureau of Labor Statistics: http://www.bls.gov/iag/tgs/iag_index_naics.htm3. An example of a great text that successfully uses first person voice to engage readers while having them quicklymaster a subject is Robert Higgens’ Analysis for Financial Management. I strongly recommend this book to anyonewho wants to learn Corporate Finance.


EXAMPLE: EVALUATING HCP'S BONDS

Let’s work through an example showing how a very basic understanding of accounting reports,some knowledge of current events, and a bit of common sense can help you make smartinvestment decisions.

Consider Healthcare Properties (HCP):HCP is a Real Estate Investment Trust (REIT)in the health and wellness industry, whichacquires, develops, leases, sells, and manageshealthcare properties. The company alsoprovides mortgage financing to healthcareproviders.

HCP is well diversified by geography andbusiness line. The company operates inCalifornia, Illinois, and Tennessee, and isheadquartered in San Francisco. HCP operatesin the medical office, hospital, senior housing,and life science segments of healthcare realestate.

Let’s say we are bond investors who are looking to make some smart bond purchases, and goback in time to March 16, 2009. I choose a date in the first quarter of 2009 (Q1-2009) because itapproximately marks the nadir of “the worst recession since the great depression” that the U.S.experienced in 2008 and 2009. This financial crisis had a profound impact on most American’s,and its effects are still seen today in the U.S.’ high unemployment rate, depressed bond yields,and extraordinary Federal Reserve Bank actions.

On March 16th, an HCP bond was on sale in the corporate bond marketplace at a price of $94.50per bond. The bond was scheduled to “mature” in six months, on September 15, 2009. “Mature”in this case means that HCP would have to pay bondholders $100 per bond plus interest of $2.80per bond on the maturity date. It’s also helpful to know that HCP’s bond was a contract thatrequired HCP to make these payments unless it declared bankruptcy on or before the maturitydate. This contractual aspect of bonds distinguishes them from stocks, which typically comewith no financial guarantees.

As investors, we’d like to know if we should buy this security. One good way to evaluate HCP’sbond is to compare its expected performance to a very low risk alternative bond with the sametime frame. Since bond investors typically demand increasing return-on-investment withincreasing risk, analyzing a low-risk bond will give us a reasonable benchmark from which toassess HCP’s bond. The U.S. Treasury issue maturing on the same day as HCP’s bond would bea good thing to consider because there is an extremely small probability that the U.S.


government will default on its obligations in the foreseeable future. Thus, the risk of this bond isvery low.

We can compare expected returns-on-investment for bonds issued by the Treasury and HCPwithout any knowledge of accounting or finance. Looking in the Treasury bond market place, wefind a treasury bond maturing on September 15, 2009, offered at a price of $100 per bond, with amaturity payout on 9/15/09 of $100 plus $0.42 interest.

With this information on HCP’s and the Treasury’s bonds, we can construct a usefulperformance-comparison table:

Bond What We Get / What We PayHCP $102.80 / $ 94.5 = 1.0878T-Bond $100.42 / $100.0 = 1.0042

Clearly, HCP’s bond looks like a much better deal. It would provide us with an 8.8% return injust about six months, while the Treasury bond would provide a return of only 0.42% over thesame period.

However, in accounting and finance, if something looks too good to be true, it almost always is.With this principle in mind, we might wonder what the catch is with HCP’s bond.

The catch, in this case, has to do with general market and macroeconomic conditions. Investorsin March 2009 had just been through a stock market crash of 39% in 2008, followed by anadditional 19% market decline in the first two months of 2009. This period was also ushering inwhat we now recognize as the worst recession since the Great Depression. These marketplaceand macroeconomic shocks caused many investors to feel that the world was coming to an endand to shy away from all but the very safest investments.

Being rational investors, who don’t let our feelings dictate our financial decisions, let’s make ourown independent assessment of HCP’s bond:

Looking at things qualitatively, we note that even in a terrible economy, demand for medicaloffice, hospital, and senior housing is almost certainly not going to collapse. In fact, some sectorsof the medical industry would probably see an increase in stress-induced demand for theirservices during periods of extreme crisis.

Using just a few, basic accounting and finance tools, we can perform a surprisingly soundquantitative analysis of HCP’s financial health, and further guide our investment decision. Tostudy HCP quantitatively, we’ll use its financial statements, which are available for free atGoogle Finance, Yahoo Finance, and many other websites.

First we’ll check HCP’s most recent Balance Sheet. This financial statement reports HCP’sassets (cash and cash-generators) and liabilities (obligations to pay cash in future) at a particularpoint in time. A Balance Sheet shows us a snapshot view of a company's financial health.


The most important portions of HCP'sBalance Sheet, for short-term bondinvestors like us, are highlighted in greenand yellow.

Current Assets (CA) are cash and assetsthat can be converted to cash within a year.Current Liabilities (CL) are obligationsthat must be paid within a year. (Note thatHCP's 9/15/09 bond maturity payment is,of course, listed on the Balance Sheet as aCL). Assets and liabilities shown in graywill be used, converted to cash, or paid offover a long time frame, and are thereforenot crucial to determining if HCP will meetits bond obligation on 9/15/2009.

This Balance Sheet shows us that HCP'scurrent assets are much larger than itscurrent liabilities ($1,978MM >>$767MM), meaning that, as of 12/31/2008,the company was in a great position tomeet its current bond maturity, as well asits other short-term obligations.

Good to Know:Here is a quick test of your understanding:Given the total size of HCP's current bond liability, and how much it must pay on each bond atmaturity, how many bonds exist? (IE: how many bonds are “outstanding”?)

So far so good for HCP's bond prospects. But what if HCP is burning through cash at a horrificrate for some reason? (This can happen – General Motors, for example, found a way to burnthrough $5BB per quarter during 2008.) HCP's Balance Sheet shows information only as of12/31/2008 and does not speak to this issue. To check for this potential problem, we'll review thecompany's recent Cash Flow Statements.

Cash Flow Statements (CF Statements) report cash inflows and outflows, measured over a periodof time. They organize any entity's cash movements into three main categories:1. Operating cash flows measure the net flow of cash from the company's day-to-day business

operations.


2. Investing cash flows record the net flow of cash from purchases and sales of long-termassets, such as property, plants and equipment (PPE), including long-term maintenance andupgrades.

3. Financing cash flows measure cash flows to and from HCP’s financial stakeholders,including shareholders (the firm's owners) and lenders (such as holders of HCP's 9/15/09-maturing bonds, bank lenders, etc).

Here are HCP's Condensed Cash Flow Statements for its last four quarters:

The statements show us that:

HCP's day-to-day operations (its Operating Activities) have been consistently generatingcash during the past year.

Its investments in the purchase and maintenance of PPE probably use less cash than itsoperations generate. During Q4 for example, (HCP's “worst” quarter from an investingcash-flow perspective), the company seems to have spent just $29MM on PPE, while itsoperations generated $113MM. In Q2 and Q3, HCP probably reported positive investingflows because it sold some properties; we would have to look deeper into the company'sfinancial statements to confirm this.

HCP has been consistently returning cash to its stakeholders – probably in the form of debtrepayment, dividends to shareholders, and/or share buybacks. For example, HCP's Q3financing flow of ($30.9)4 could represent a debt payoff of $10MM, a dividend payout of$10MM, and share-repurchases of $10.9MM. (We would again need to look more deeply tofind exact amounts). All of these transactions suggest that HCP chas had no need to raisecash from equity or debt stakeholders. This is good news for potential short-term-bond-investors like us.

Taking all the cash-flow categories into consideration, it’s safe to conclude that HCP's operationsare consistently generating more than enough cash to maintain its long-term assets and providecash to its stakeholders, while still increasing its overall cash position. So clearly the companyhas no cash burn issues.

4 In accounting and finance, negative numbers are often written inside parenthesis instead of being preceded by aminus sign. IE: ($30.9) instead of -$30.9.


We can now summarize our independent analysis of HCP's bond as follows: Given HCP'sfinancial strengths as shown on its recent Balance Sheet and Cash Flow Statements, it seemshighly probable that it will meet its 9/15 bond obligation with ease. The bond's price is probablydepressed because of the generalized fear in the stock and bond markets so prevalent at this time(3/16/2009).

So we probably want to buy this bond. To be sure, we still should make several morecommonsense checks, including:

Taking a closer look at the company's recent investing cash flows, to see what caused thelarge positive numbers reported above in Q2 and Q3, and to estimate HCP's “steady state”investing flows in quarters when it does not make large purchases or sales of buildings.

Performing a careful scan of company-related news (again easily completed with a freeYahoo or Google company news search). We'd want to be on the lookout for near-term-future problems that may cause HCP to bleed cash, even though HCP has not listed theseproblems as liabilities. (HCP has the right not to list such items if, in agreement with itsaccountant, the potential problems have a small probability of being realized. An examplewould be a forthcoming Medicaid audit of a large HCP customer, which might result in thetenant going out of business and ceasing rent payments).

EpilogueUsing its positive cash flow and large cache of current assets, HCP easily raised the $103MMneeded to meet its 9/15/2009 bond maturity. Bondholders who purchased on 3/16/2009 at$94.50 per bond enjoyed an 8.8% return in just six months5, or 18.4% per year on an annualizedbasis. (Measuring returns on an annual basis – IE: asking what would this investment return peryear? – is common because it provides a nice, apples-to-apples method of comparinginvestments of differing durations. We will develop the math for this in a later chapter).

If you followed the above example with interest, you will probably enjoy the rest of this text andlearning more about accounting and finance. If not, you should probably stop here unless youhave a compelling career-related need to become familiar with these subjects. If the examplereally excited you – raising interesting questions about stocks vs. bonds, and the effectmacroeconomics and market sentiment has on individual investments – you may want toconsider a career related to accounting and/or finance. On the other hand, such extremeaccounting/finance-induced excitement may simply be a sign that you need to get a life.

5 ($102.80 - $94.5) / $ 94.5 = 0.088 or 8.8%


ACCOUNTING BASICS

CHAPTER 2


PRIMARY CHARACTERISTICS OF ACCOUNTING

Warren Buffet's famous description of accounting “the language of business” is apt. Accountinghas a unique vocabulary and expressive structure, designed to provide information on entitiesand to help understand their economics. A more specific way to think about accounting is as auniversally accepted, largely rule-based, method of identifying, measuring, and reporting anentity's financial information.

Accounting aims to help anyone interested in the financial aspects of a company, by showing: the amounts of financial resources controlled by the entity how these resources were financed, or paid for the financial results achieved by using these resourcesThe parties interested in this information include the entity's own branch managers, its CFO,CEO, and shareholders, as well as potential investors and lenders, regulators, and tax collectors.

ACCRUAL VS. CASH ACCOUNTINGThere are two main types of Financial Accounting – Cash Accounting and Accrual Accounting.Cash Accounting is very simple and easy to master. It includes the recording of changes to anentity's cash, keeping track of the entity's total cash, and reporting on these two things.

The downside of Cash Accounting is that it does not address many issues that are needed to fullyassess the financial health of a company, such as an obligation to pay cash in the future. (Suchobligations, as we saw in the HCP example, are called liabilities and include things like HCP'sneed to meet its forthcoming bond-contract payments). For this reason, Cash Accounting isusually applied only to small, very simple businesses.

Accrual Accounting measures financial events as they come into existence or accumulate,regardless of when related cash transactions happen. So, for example, HCP would recognize atenant’s rental revenue at the end of each month, even for tenants who may be late in makingtheir cash payments. Similarly, it would recognize an expense for heating oil as soon as it wasinvoiced, several weeks or months before the invoice is paid.

Accrual Accounting is well named (unlike some other accounting terms that we will encountershortly) in the sense that it measures financial events as they accrue, regardless of when cashtransactions happen. In fact, Webster's online dictionary defines accrual as “to come intoexistence,” or “to accumulate or be periodically incremented,” which is almost the same wordingwe used above to define this type of accounting.

The notion of accruing and its various verb and noun forms is fundamental to AccrualAccounting. We will use it in several ways, such as: HCP's accrued Accounts Payable liability was $308.1MM on 12/31/2008

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Interest on GM's short-term loan accrues on a daily basis Apple's employees accrue vacation time at the rate of one day per month worked

Because Accrual Accounting provides much more useful financial information than CashAccounting, virtually all but the smallest, simplest businesses use it. Therefore, we will focusprimarily on this accounting system.

Another form of accounting, called Managerial Accounting is centered around questions like“How much of an entity's lighting bill should be charged to its HR department versus itsaccounting division, when both groups share the same space?” Managerial Accountinginformation is prepared specifically for a company's managers, and not for other stakeholders.When compared to Managerial Accounting, both Accrual Accounting and Cash Accounting areconsidered branches of Financial Accounting. This text covers only Financial Accounting.

The rules for Accrual Accounting are established in the US by the non-profit, FinancialAccounting Standards Board, or FASB. FASB’s rules are often referred to as GenerallyAccepted Accounting Principals, or GAAP. Throughout the text, I use “GAAP Accounting” and“Accrual Accounting” interchangeably, when referring to Financial Accounting practices in theUS.

EXAMPLE:Fill in the missing portions of the table below to ensure your mastery of the distinction betweenAccrual and Cash Accounting:

Solution:


CONCEPTS GOVERNING ACCOUNTING

There are twelve key concepts that provide a framework for Accrual Accounting:1. Accrual2. Money Measurement3. Duality4. Entity5. Going Concern6. Cost7. Accounting Period8. Conservatism9. Realization10. Matching11. Consistency12. Materiality

We will examine them several at-a-time, as they come up. Let’s look at the Accrual and MoneyMeasurement concepts now.

The Accrual Concept says to measure financial events when they are accrued (when experiencedor as accumulated), irrespective of when related cash transactions occur. It's simply arestatement of the definition of Accrual Accounting. The Accrual Concept is clearlyfoundational, and is Accrual Accounting's most important concept.

The Accrual Concept works with Apple, as we've seen in the above example, as follows: Apple records revenue (sales) when its products or services are delivered The company registers expenses as soon as a financial obligation to pay someone is createdApple's recording of revenue and expense is unrelated to the associated flow of cash.

The Money Measurement Concept says to consideronly items and transactions that can be convenientlymeasured and reported in cash ($) or another currency.So Apple, for example, records its cash cost of buying1,000 chip-sets, and the amount it pays Tim Cook peryear. Apple does not report Tim Cook’s value toApple, although the amount is substantial, because it’sdifficult to measure his value. (50 randomly chosenApple employees would probably provide 50 uniqueestimates of Cook's value to the firm). Similarly,Apple does not report the value of its logo, eventhough it’s clearly worth a fortune.


However, if Lenovo were to buy Apple someday (stranger things have happened), it would thenreport the value of the logo. This is because Lenovo's mergers and acquisitions group would, aspart of its determination of the overall purchase price of Apple, compute the logo's worth toLenovo. This value could then be conveniently looked up whenever Lenovo created a set ofaccounting reports. Apple, on the other hand, did not purchase its logo, so it does not have aconvenient, consensually-agreed value to place on it.


IMPORTANT ACCOUNTING QUANTITIES

The three most important Financial Accounting quantities are Assets, Liabilities, and Owners'Equity.

ASSETSAssets are valuables that are owned or controlled by an entity, including specifically: cash, thingsto be converted to cash, and things used to generate cash. Apple, for example, has these assets: Functioning iPhones held in its warehouses

(Called “Inventory”) Invoices delivered to AT&T that have not been paid

(“Accounts Receivable”) Land and buildings owned by the company

(“Land,” and “Property, Plant and Equipment”)

Apple does not consider these items assets: 200 Macs that have been completely destroyed by rain

(These are by definition no longer valuable) The head of its R&D department

(Apple may have an employment contract with her {which would be an asset}, butobviously the company does not own this employee)

HCP's assets include: Its cash Property plant and equipment

(Including its land, its buildings, and the trucks/lawnmowers/etc. it uses to maintain itsbuildings)

Assets are usually measured at cost, or cost minus wear. So for accounting purposes, Apple'sfunctioning iPhones are valued at the price paid to Foxconn for them, and a truck of HCP's isvalued at the price paid for it minus the amount the vehicle has worn-out since purchase. (Theamount of wear is called Accumulated Depreciation, which we will study carefully in laterchapters).

Assets whose market value can be quickly, transparently, and consensually determined aremeasured at their market value. Very few assets fit into this category. Examples include cashand other currencies, stock options, and commodity futures contracts.


LIABILITIESLiabilities are financial obligations of an entity, representing a commitment to pay out cash at afuture time. Liabilities are almost always measured at the contractual value of the required,future payout.

Example liabilities of Apple's include: Unpaid invoices from Foxconn

(Called “Accounts Payable”) The outstanding mortgage balance on its headquarters building

(“Mortgage” or “Debt”) Salaries earned by its employees that have not yet been paid

(“Accrued Salary” or “Accrued Liabilities”)

Liabilities of HCP's are: Unpaid invoices owed to its heating oil supplier.

(“Accounts Payable”). Bond principal and interest owed.

(“Debt” and “Accrued Interest” respectively). The unpaid balance of the loan it took out to purchase the truck mentioned above. (“Debt”).

OWNERS' EQUITYOwners' Equity is defined to be an entity's total assets minus its total liabilities. IE:

Equity ≡ Assets – Liabilities1 22j)2

With this definition, equity is also mathematically equal to:All the cash infusions put into the company by its owners since the firm's inception, plus all theNet Income earned by the firm over its lifetime (or revenues minus expenses over the firm's life),minus all the dividends paid to the firm's owners, since the entity was created.

Using a mathematical notation, we can write this in a shorthand form:

Owners’ Equity = Σ Cash Infusions by Owners+ Σ Net Income

- Σ Dividends Paid to Owners

(Where “Σ” means the sum over entity's entire life).

By formalizing and abbreviating terms:1 Throughout this text, the triple-bar equal symbol ( ≡ ) is used to mean “defined as” or “defined to be equal to”.2 The numbering of most equations in this text is arbitrary. This system enables me to revise and expandmathematical portions of the book without renumbering.


Cash infusions by owners is formally called Paid in Capital and abbreviated as PIC. Net Income is abbreviated as NI Dividends paid to owners are formally called Dividends, and abbrefiated as Div.

We can further shorten the above equality into:Equity = Σ PIC + Σ NI - Σ Div 22k)

Throughout this text, we will use both of the above equity equalities { 22j) and 22k) }.

Like many accounting quantities, some of the above long-form terms go by various alternativenames. Owners’ equity is also known as “book equity,” “book value,” or simply “equity,” as usedabove. Similarly, Net Income is often identified as “Net Earnings” or “Earnings.”

Speed Learning Tip:A significant part of 'the language of accounting' can be mastered by simply learning thedefinitions of important terms, and the various names given to them.

Below is HCP's complete Balance Sheet as of 12/31/2008, showing its assets, liabilities, andequity:

Relationship Between Owners' Equity and the Value of a FirmThe definition of Owners Equity,

Equity ≡ Assets – Liabilities

suggests that this quantity is closely linked to the value of a firm. By subtracting a firm'sfinancial obligations (liabilities) from its financial valuables (assets), we are left with a pile ofstuff (say “net assets”) that could be sold, and the proceeds could be distributed to the firm'sowners (usually called its shareholders). In this sense, equity is an approximation of what thefirm is worth to its owners, or an approximation of the value of the entity.


I say “approximation” because equity, as defined for Financial Accounting, misses the value ofan entity in several ways. First, the value of the assets as recorded may not represent the actualamount they would sell for. Apple’s iPhone inventory, for example, is recorded at the cost of thephones – hopefully they could be sold for much more than this. Also, if HCP bought some of itsbuildings during 2007 (the height of the real-estate bubble), their value is probably much lessthan their cost.

Equally important, some items of great financial value may not be recorded by an entity asassets. Recall that, for Financial Accounting purposes, Apple does not record the value of itslogo, although it is clearly worth a fortune.

Because of these issues, it’s safe to say that equity, as measured by Financial Accounting, is notusually a true representation of an entity's worth. However, by altering a firm's equity value toaccount for these quirks, we can compute a pretty good valuation of many firms. The BalanceSheet Valuation Method aims to estimate the worth of an entity by using this process.


THE BALANCE SHEET VALUATION METHOD

The Balance Sheet Valuation Method is a classic technique for determining the worth ofentities, which is used by many prominent value investors. Here is how it works:

Step Task

1. Recall: Equity(accrual) = Assets(accrual) – Liabilities2. Replace the costs of the firm's assets with the market values of these items.3. Add value of any assets that are not included on the entity's accrual balance sheet.

(This includes brand values, patents, etc.)4. Compute: Assets(market value {mv}) = Assets(accrual) +/- Adjustments5. Recall that liabilities are almost always recorded at market value, and compute:

Equity(true) = Assets(mv) – Liabilities

Equity(true) is considered to be a decent approximation of the firm's value to its owners.

The Balance Sheet Valuation Method provides one way to help decide whether or not to purchasea publicly-traded entity's stock. If, for example, we wanted to know if we should purchase someof HCP's stock, we could proceed as follows:a) Compute HCP's Equity(true) as prescribed above. This is our estimate of the firm's value.

b) Determine the marketplace's view of the value of HCP's equity. (Warren Buffet might saythis as “determine what 'Mr. Market' believes the firm is worth”). This is easily done by:

i) Looking up the price-per-share of HCP, and the total number of shares outstanding. (Both are available at Yahoo Finance or Google Finance).

ii) Noting that, if we own all the outstanding shares, we own the entire firm.

iii) Computing Market Price of Firm = Price-per-Share * Number of Shares Outstanding.

c) Compare the Market Price of HCP to Equity(true). Then, if the Market Price of HCP was muchless than our estimate of the firm's value (Equity(true)), then we probably would want to buysome shares of HCP stock.

What is Wrong with This Picture?You may think the above procedure seems a little too easy to be correct. After all, Warren Buffetis one of the most successful investors of the 20th century, and most good investment managershave MBAs and/or CFAs, as well as years of experience. If the Balance Sheet Valuation Methodis so simple, why does it take such experienced practitioners to successfully apply it?

In practice, it’s difficult to use the Balance Sheet Valuation Method in real situations for severalreasons. First, transforming a company's assets from cost-basis to market values is not easy. InHCP's case, we would have to know the market value for each of its medical office/hospital/labbuildings. These values can only known for sure when the buildings are actually sold. Second,estimating the value of things like logos or a company's brands is hard to pin down (which is a


big reason why these quantities are omitted from the Financial Accounting system). Finally, anyBalance-Sheet-based assessment method – which necessarily considers assets, liabilities andequity at a single point in time – does not usually work for very quickly growing firms, whoseBalance Sheets are inexorably expanding.

CONCEPTS GOVERNING ACCOUNTING, CONTINUED

Recall our list of Financial Accounting concepts:

1. Accrual2. Money Measurement3. Duality4. Entity5. Going Concern6. Cost7. Accounting Period8. Conservatism9. Realization10. Matching11. Consistency12. Materiality

Now is a good time to cover the Duality Concept, as it relates directly to the relationshipbetween assets, liabilities, and equity. The Duality Concept states that:

Assets = Liabilities + Equity 22q)

is true at all times, under all circumstances.

The duality equation, 22q), is called the Fundamental Accounting Equation because of itsfoundational importance. It is derived by simply re-arranging the terms of the equation we usedto define shareholders' equity {equation 22j) above}.

The duality equation has two important implications. First, change in assets over any timeperiod equals change in liabilities plus equity over the same period. IE:

Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity), where: 22m)

Δ(Assets) = AssetsT1 – AssetsT2, etc.(“ Δ” is pronounced “delta,” and means “change to” or “change from one time toanother”).

Δ(OE) = Δ(PIC) + Δ(NI) - Δ(Div)

Δ(NI) = Δ(Revenue – Expense)

Equation 22m) is called the delta form of the Fundamental Accounting Equation 22q). It isequally important as the equation 22q) form.


Second, every accounting event will have a dual impact on an entity's accounting records. Everytime a company experiences an accounting event (ie: a micro-economic event), its assets,liabilities and/or equity will change such that equation 22m) holds:

Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity)

Clearly, at least two non-zero changes are required for this form of the duality equation to besatisfied. For this reason, Accrual Accounting is often called a “double-entry” accountingsystem.


RECORDING ACCOUNTING EVENTS

Accounting events are anything that cause a change in assets, liabilities, or equity. For a givenentity, accounting events are usually the same thing as microeconomic events. For anyaccounting event,

Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity)

will hold true, and we will use this to help us record accounting transactions.

As we identify accounting events, we will see that most of them are recorded as experienced, butrecording of some transactions may be postponed until an entity prepares a set of financialstatements (ie: a Balance Sheet, Cash Flow Statement, etc.).

EXAMPLE:RECORDING ACCOUNTING EVENTS FOR WEST END ADVISORS, LLC.West End Advisors, LLC (WEA) provides investment management and financial planningservices to individuals and institutional investors. The firm is a registered investment advisor,regulated by New York State and the SEC. It was founded in 2002.

During its first quarter of operations, WEA experienced the following events:

1. The company is formed2. The owners pay in $10,000 (PIC) for 10,000 shares3. The company buys $5,000 of furniture and computers, using a company credit card4. The firm invoices $8,000 in revenue. Customers paid $4,000 cash at time of invoicing, and

are expected to pay the remaining $4,000 within 60 days.5. The company incurs and pays salary expense of $3,000, in cash6. The firm incurs and pays rent expense of $1,000, in cash7. The company pays its owners $2,000 dividend.

Let’s record these events, using a duality-preserving tool called a Transaction Table.Transaction Tables look like this:


The top row is an expression of the delta form of the duality equation, which must be satisfiedfor the recording of each event. Owners Equity is broken out into its constituent parts: PIC (PaidIn Capital), NI = Revenue – Expense, and Div (Dividends).

The next row provides the labels for the transactions that will be recorded below it. The finalrow, Transaction 1, is where the first event will be recorded.

Here is WEA's partially completed transaction table with space for all its Q1 events and someitems filled in:

Event 1 (Transaction 1) is recorded as zeros because it did not affect WEA's assets, liabilities, orequity. Event 2 records the $10,000 in cash the firm received from its owners as an asset, andbalances this amount with a $10,000 increase in Paid in Capital (PIC, a component of equity).

Try to fill in the rest of the table, using these hints:

Event 3: Furniture and computers are considered part of Property, Plant and Equipment, PPE,or Net PPE. Using a company credit card creates a liability called a Note Payable or Note. Thisis similar to an Account Payable liability, which is generated by receipt of an invoice.

Event 4: The $8,000 revenue is balanced by two assets of $4,000 each. When a company issuesan invoice, it generates an Accounts Receivable asset.

Events 5, 6, and 7 are more straightforward. You may check your entries for these events, aswell as for events 3 and 4, by reviewing the completed table below. Note that at the end of Q1,WEA's total assets equal its total liabilities plus its total equity:


Solution:


MORE MEANINGS OFASSETS = LIABILITIES + OWNERS’ EQUITY

One reason the Fundamental Accounting Equation is so fundamental is that, in addition toproviding the framework for recording accounting events, it helps us characterize the financialstructure of an entity in several different ways. Here are three example ways to broaden yourunderstanding of Assets = Liabilities + Equity:

1. The cost of entity’s resources (assets)= the amount financed by creditors (liabilities)+ the amount financed by owners (equity: paid in capital minus dividends)

and by operating the business (equity: net income)

2. Uses of capital (assets) = Sources of capital (liabilities and equity)

3. The amount invested in entity’s resources (assets) = creditors’ claims (liabilities)

+ owners’ claim to leftovers (equity)

(This form is especially helpful when a company declares bankruptcy. When a companygoes bankrupt, creditors are paid off first, and then equity-holders are paid, if anything isleftover for them).


MADDENING ASPECTS OF ACCOUNTING

In my humble opinion, there are several maddening aspects of Accrual Accounting. We'vealready encountered the first one – that many important terms have several names. For example,we've seen that owners' equity is sometimes called “book value,” “shareholders' equity,” etc.Similarly, some companies call Accounts Receivable something like “Amounts Owed FromCustomers.”

A second, worse problem with accounting terms is that some words have ambiguous meanings,which are difficult to resolve. For example, the “price to earnings ratio” (PE ratio) of a stockmay refer to a ratio taken on a historical basis, a projected basis, or may be an average ofhistorical and projected numbers. Problems like this may be impossible to resolve withoutquestioning the person using the ambiguous term.

A final (for now) potentially maddening aspect of accounting, which we have also glimpsed, isthat exceptions exist to many of its important rules. For example, most assets are recorded atcost or cost minus wear, but some assets remain marked to their market value at all times.

Speed Learning Tip:As a budding finance professional coming to the field from engineering, these aspects ofaccounting used to drive me bats. In most of the engineering realm, definitions are precise, termsare uni-labeled, and very few exceptions exist to important rules, laws, and theorems. I quicklylearned that to master accounting, I'd have to take its quirks and vagaries on their own terms, andsimply memorize as many of its oddities as possible. Additionally, I tried to mimic the physicistRichard Feynman’s fearless propensity to ask a speaker (or writer) clarifying questions, evenwhen the rest of the audience seemed to perfectly understand the subject at hand. (IE: Hiscourage to risk looking stupid to a room full of smart peers). These techniques worked well forme and I recommend them to readers of this text.


THE BALANCE SHEET

CHAPTER 3


CONCEPTS GOVERNING ACCOUNTING

Before jumping into a detailed discussion of Balance Sheets, let’s cover three accountingconcepts that will help us understand how these reports work.

1. Accrual.2. Money measurement.3. Duality.4. Entity.5. Going concern.6. Cost.7. Accounting period.8. Conservatism.9. Realization.10. Matching.11. Consistency.12. Materiality.

The Entity Concept says to track information on an individual entity (company), not its owners,customers, lenders, etc. Let’s consider the sole owner of ChlorophytaFuel LLC, which makesbiofuel from algae. As shown in the table below, if the owner transfers $100,000 ($100K) fromthe firm’s checking account to her personal savings account, the effect on the entity is to havecash and equity reduced by $100K, but the transaction has no net effect on the owner’s overallnet worth. Financial accounting is concerned with the transaction’s effect on ChlorophytaFuel,not the impact on the firm’s owner.

Effect on Effect onEvent Entity: Firm’s owner

Sole owner pulls$100K from her firm.

-$100 Cash,-$100 Equity

No net effect

The Going Concern concept says to assume that an entity will continue operating indefinitely.An alternative assumption is to assume that the entity will liquidate or file for bankruptcyprotection in the foreseeable future. When the alternative assumption is most appropriate for agiven firm, it must state that it is at risk of losing its Going Concern status in the notes to itsfinancial statements. (IE: the notes to its Balance Sheet, Income Statement, etc). If the entity issubsequently liquidated in bankruptcy, it follows Liquidation Accounting rules, in which itsasset costs are replaced by their liquidation market values.

Before covering the Cost Concept, recall that an entity’s assets are:

§ economic resources,

CHAPTER3–THEBALANCESHEET PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

§ cash, anything that will be exchanged for cash, or anything that helps the firm generatecash, and

§ things that are owned or controlled by the entity.

With this in mind, the Cost Concept says that most assets are recorded at cost (the price paid forthem), or cost minus wear. Exceptions include many assets whose market values may be easily,quickly, and consensually looked up; examples include: money market funds, shares of publiclytraded stock or derivatives, and bonds held for trading or sale before maturity. (Bonds intendedto be held until maturity are handled differently and their accounting treatment is beyond thescope of this text).

An example of an asset that is valued at cost permanently is land. Unlike the price of a publicly-traded stock, the market value of an entity’s land cannot be looked up quickly on a transparentexchange. Additionally, while the equity market provides a consensus value for the price of SPYshares, the cost of a piece of land will vary by appraiser, with a low probability that all appraiserswould price the land equally. This difficulty in quickly determining a universally agreed price isone reason that financial accounting measures land at cost. For most assets, financial accountingaims to strike a balance between ease of lookup and market-value accuracy, but it usually errs onthe side of quick and easily-verifiable lookup.

Most Property, Plant and Equipment (PPE) assets, such as entire manufacturing plants, trucks,cars, machines and even some computers, are recorded by financial accounting at “cost minuswear.” The idea here is to account for the finite useful life of these assets. So for example, inyear 20X0 a company may purchase a delivery truck for $10,000, estimate its useful life at 10years, and assume that it will wear out at the linear rate of 10% per year. In year 20X5, thecompany would report the truck’s value at $5,000, reflecting five years worth of wear. In thiscase, the company may say that the truck’s “book value” is $5,000, which in this context meansthe same thing as “cost minus wear” to-date. (Unfortunately, “book value” has differentmeanings in other contexts, as we will see later).

Another exception to the notion of valuing assets at cost or cost minus wear occurs when thevalue of an asset is “marked down” or “written down” to its market value. Writing down thevalue of an asset is done if and when the asset’s market value falls below its book value (cost orcost minus wear). In this case the asset’s financial accounting value is reduced to its marketprice.

This situation is described as valuing assets at “the lower of cost or market value,” and is mostcommonly seen in assets such as inventory, which describes an entity’s products waiting to besold. For example, say Blackberry has recently paid Foxconn $100 per assembled smartphonefor a bunch of Blackberry Z10 devices. On purchase, Blackberry records the phones at $100each in its inventory account. Soon after these lame devices go on sale, AT&T, Verizon andSprint report that consumer demand for them is very low, and that they will only pay $75 perZ10. On hearing this news, Blackberry would write down the value of its remaining inventory to$75 per phone.


FINANCIAL STATEMENTS

As noted above and in Chapter 1, accounting information is summarized in reports, called“Financial Statements.” The primary statements are the Balance Sheet, Income Statement,Statement of Cash Flows, and Statement of Owners’ Equity.

For a given time period (monthly, quarterly, yearly, etc) all financial statements can be createdby drawing on the complete history of an entity’s accounting transactions from inception, or byusing the firm’s most recently-reported financial statements and all its accounting transactionsfor the subsequent (latest) reporting period. The first method is typically used by accountingsoftware packages such as Quickbookstm or AccountingBasicstm. The second method is muchless tedious to perform manually, and it is a great method for learning accounting. It willtherefore be our method of choice in most cases.

Here is a bullet-point summary of the four key financial reports, outlining their missions. TheBalance Sheet information is highlighted in red, as we will cover it first.

Balance Sheet: Reports financial assets, liabilities (obligations) and equity at a single point in time. It is a snapshot report, (showing levels of assets, liabilities and equity).

Income statement: Shows changes in equity caused by firm’s day-to-day business operations. It’s a flow report, showing movement of some cash and accruals over a period of time.

Statement of owners’ equity: Shows details of other changes to equity over time. It’s also a flow report.

Statement of cash flows: Reports the flow of cash only over a period of time. Sorts these movements into operating, investing, and financing buckets. Like the Income and Owner’s Equity statements, it’s also a flow report, making the Balance

Sheet our only snapshot or level report.

THE BALANCE SHEETAs noted above, the Balance Sheet reports assets, liabilities and equity at a single point in time,and it preserves duality. A third Balance Sheet mandate is to provide some measure of detail,especially for assets and liabilities.


With these requirements in mind, let’s try to create a Balance Sheet for WEA’s first quarter ofoperations (as covered in Chapter 1). Recall WEA’s Transaction Table for Q1:

From the End-of-Quarter (EOQ) totals at the bottom of the table we can easily create an ultra-condensed Balance Sheet:

WEA Balance Sheet as of EOQ 1 ($K, UON)1

Assets Liabilities Equity $17 $5 $12

This report satisfies parts of its mission in the sense that it reports Assets, Liabilities and Equityat point in time, and because it has preserved duality. However, it provides virtually no usefuldetail, and therefore it fails to meet its overall requirements.

In most accounting classes, this would be a “D”-worthy effort (or worse), so let’s try to do better.We can easily improve the Balance Sheet by simply reporting information from WEA’sindividual asset, liability and equity accounts. To show account-level detail, we first sort all ofWEA’s Q1 transactions by account, producing this result:

1 “$K” is shorthand for “thousands of dollars.” “UON” stands for “Unless Otherwise Noted.” Both terms areused throughout this text.


The first line above refers to total asset, liability and equity levels at the beginning of the period(BOP). Since WEA began its life during the period, all its BOP values are $0. As we sort, wedo not care about transaction order or date, because we are only concerned with totals at the endof the quarter. (Remember the Balance Sheet is a snapshot report, which in this case will showaccumulated levels of assets, liabilities and equity at the end of Q1).

Next, we compute EOQ subtotals for each account. Our resulting new Balance Sheet displaysjust these subtotals and grand totals for assets, liabilities and equity:

Note that Net Income ≡ Revenue – Expense2, has been condensed into one line. This iscustomary as WEA’s Income Statement will cover the details of its sales (revenue) and expensesin great detail.

Like our ultra-condensed effort, this Balance Sheet reports Assets, Liabilities and Equity at pointin time, and preserves duality. Unlike our almost-failing earlier work, this report also provides agood level of detail. As such this Balance Sheet completely fulfills its mission and is fine as-is.

Here are some important things to remember about this and all Balance Sheets:

2 Reminder: Throughout this text, the triple-bar equal symbol ( ≡ ) is used to mean “defined as” or “defined to beequal to”.


Balance Sheets report total assets, liabilities, equity at the end of a period. Total means allitems measured cumulatively from the inception of the firm.

WEA's EOP account balances, for each account, are computed as:EOP balance = BOP balance + Σ changes in period

In general, adding BOP balances is necessary to capture the cumulative changes in eachaccount measured from the firm’s inception. In our example, all BOP balances were zero,because this was the first period of the firm's existence.

Now that we know how to create a Balance Sheet, it’s helpful (and hopefully interesting) toexplore its utility and limitations. Specifically, let’s see what WEA’s Q1 Balance Sheet does anddoes not tell us.

The Balance Sheet tells us that, As of EOQ 1, WEA: Had $8K cash. Expected to get $4K more “soon,” as seen by Accounts Receivable (AR) = $4K. Owned property, plant and equipment with a net book value of $5K. Owed $5K on a note. Owners invested $10K in the company. Total cumulative “Net Income” (NI) of the company is $4K.

WEA’s EOQ 1 Balance Sheet doesn’t tell us several things we might like to know, including: How “soon” does it expect to receive cash payment for its $4K of Accounts Receivable? How old is its property, plant and equipment, and what is its total wear? (net PPE ≡ cost –

wear). What is the interest rate on its note owed, and when must the note be repaid? How much did each individual owner invest in WEA in order to reach the $10K total? What were the company’s revenue and expense that yielded Net Income of $4K?

Answers to these questions come from several sources, including: The “Notes” accompanying WEA’s financial statements.

Whenever a firm produces a set of financial statements, it is required to prepare anaccompanying set of written notes (called formally “Notes” accompanying the financialstatements”) that provide backup detail for the numbers in the statements. In WEA’s case,the notes would explain, for example: The firm’s Accounts Receivable is expected to be paid within 60 days. Its Note must be paid down $1K per year until paid off, and interest on any unpaid

balance accrues at 8% per year.

The Statement of Owners’ EquityThis financial report provides detailed information on the firm’s equity accounts. For WEAit would show that each of WEA’s two owners invested $5K in the firm.

The Income Statement


As noted above, this statement itemizes the revenues and expenses that result in the firm’sNet Income.

EXAMPLE:VALUING WEA WITH THE BALANCE SHEET VALUATION METHOD

Let’s use the Balance Sheet Valuation Method to value WEA as of its EOQ 1. Let’s assume atthe end of Q1: WEA’s owners have decided to shut down the firm immediately. All Accounts Receivable will be paid. The firm’s PPE includes only refurbished computers and well-used IKEA furniture. WEA’s Q1 Balance Sheet is as computed above:

WEA’s owners are offering to sell you the firm for $10K.

Assuming you have a free $10K to invest, you’d like to know if you should buy the firm.Hopefully your decision will be based on whether or not you can profit from this purchase.

At a first glance of WEA’s Balance Sheet, you might decide to invest because the firm’s Equity(Assets – Liabilities) is reported as $12K, which could leave you a quick $2K profit on your$10K investment. You would realize this profit by selling WEA’s assets and paying off itsliabilities.

The fatal flaws of this analysis are that WEA’s Balance Sheet assets are reported at cost or cost-minus-wear, and some assets (like WEA’s brand value) are not reported at all. As we saw in theprevious chapter, the Balance Sheet Valuation Method aims to create a better estimate for thetrue value of the firm’s equity by correcting for these problems. Here is a reminder of how themethod works:

1. Recall that Equity(accrual) = Assets(accrual) – Liabilities

2. Replace accrual accounting’s measure of WEA’s reported assets with their market values.

3. Add the value of any assets that are not included on WEA’s accrual Balance Sheet (IE: theawesome power of the WEA brand, or the value of any patents it may hold). Then:

Assets(market value) = Assets(accrual) +/– these adjustments.

4. Apply: Equity(true) = Assets(market value) – Liabilities


Equity(true) is a decent approximation of the firm’s true value. For WEA, this represents themarket price realized from selling the firm’s assets minus the payoff of the firm’s liabilities.Note that we have not changed the value of WEA’s liabilities. This is because accrualaccounting reports most liabilities at their true cash value.

As a potential buyer of the firm, you should estimate a reasonable lower bound for WEA’s value.Accordingly, let’s assume that WEA’s PPE is worthless, and its brand name is its onlyunreported asset. (Given that the firm existed for just one quarter, it’s safe to assume thatWEA’s brand value is zero). Applying these adjustments to WEA’s assets gives us this true-value Balance Sheet:

Assets(true value) Liabilities Equity(true value)

Cash $8K Note $5K Computed asAR $4K Assets - LiabilitiesPPE $0KTotal $12K $5K $7K = $12K - $5K

As a budding value investor, estimating WEA’s true-value Balance Sheet tells you that the firmis probably worth about $7K, so you would turn down the offer to purchase the firm for $10K.

The Balance Sheet valuation method is a great way to estimate the worth of many entities. Thissaid, it is often difficult to apply in practice because the market value of many assets is difficultto estimate accurately. The method also does not work well for fast growing firms, whoseadjusted balance sheets do not capture their ongoing values. These problems are discussed morethoroughly in the final chapter of this text.


A DETAILED LOOK ATA LARGE COMPANY’S BALANCE SHEET

Lets look in-detail at a Balance Sheet of Healthcare Properties (HCP), the healthcare REIT weexamined in Chapter 1. HCP’s operations are more complicated that WEA’s, and accordingly itsBalance Sheet contains – like most large, publicly-traded corporations – many more quantities.Here is HCP’s balance sheet for EOY 2009, with its assets emphasized:

At the risk of being extremely boring and repetitive, let’s remind ourselves what assets are beforelooking carefully at each of HCP’s. Recall that assets must: Be economic resources.

(Resources that will provide monetary benefits, such as cash, things to be converted to cash,or items used to generate cash.

Be controlled by the entity. Have a conveniently measurable cost at time of their acquisition.

Another way to think of assets, which often helps to clarify the accounting characterization ofmicro-economic events, is: Any balance sheet item that, if converted to cash today, would bring cash to the entity.

We will see how this view of assets works shortly.


CURRENT ASSETSNotice that HCP’s Assets are separated into Current Assets and all other Assets. Current Assetsare defined as either:

1. Cash and Cash Equivalents, or

2. Other assets that HCP intends to convert to cash or to consume within one year of theBalance Sheet’s snapshot date.3

HCP’s first-listed Current Asset is Cash and Cash Equivalents. Cash Equivalents includeinvestments in Money Market funds and other “demand deposits”. Demand deposits havevirtually no risk of losing their value, and may be immediately converted to cash at any time.Certificates of Deposit (CDs), unlike Money Market funds, are not Cash Equivalents, becauseCD investors may only receive their initial investment (“principal”) back at a certain time unlessthey pay an early-repayment penalty.

Other current Assets of HCP’s include Marketable Securities, Net Receivables, NotesReceivable, and Pre-paid Expenses. Let’s look at each of these in turn.

Marketable Securities include are readily marketable investments that the company expects toconvert to cash within a year. Examples include:

A one-year Treasury Bill.

A six-month CD.

IBM bonds maturing in six months.

Shares of GE stock to be sold in one month.

Net Receivables, like Accounts Receivable (AR), measure the amount owed an entity bycustomers for services performed or products purchased. Receivables are usually evidenced by astack of unpaid invoices issued by the company.

A company’s Net Receivables are less than its total AR by a small amount, to account for thefact that not all invoices will be paid in full. (Determining the amount to subtract from AR isbeyond the scope of this text). Inevitably, some of HCP’s myriad of customers will, forwhatever reason, be unable or unwilling to pay what they owe.

As mentioned in Chapter 1, Notes Receivable represents a set of short agreements, signed by anentity’s customers, affiliates or acquaintances, pledging to pay a certain amount to the entitywithin a certain time. The time period may be greater than one year, implying that some Notesmay not be current assets. (Notes to be repaid in more than a year would be Long-term Assets).

3 If a firm’s operating cycle is longer than a year, operating assets intended to be converted to cash or used up areincluded in Current Assets, even if this may take more than a year. An example would be housing inventory fora homebuilding company that may take longer than a year to build and sell a house.


HCP’s Notes provide it with a stronger claim for payment than its invoices, as the signed Notescontractually obligate HCP’s customers to pay the amounts specified. When issuing invoices bycontrast, HCP is relying on the good faith of its customers to pay the amounts charged.

Note agreements typically call for payment of the total amount owed (principal), plus interest.As noted in Chapter 1, credit cards are an unusual example of notes, as the credit card holderagrees in writing to pay for everything charged on the card, and to pay interest on anyoutstanding balance owed.

Prepaid Expenses represent, logically enough, an entity’s prepayment of future expenditures.Future expenditures associated with Prepaid Assets may be due in more than a year, so likeNotes Receivable, these assets may be either short-term or long-term.

Good to know:Some companies confusingly label their Pre-paid Expenses as “Deferred Expenses.”

Here is an example showing how some of HCP’s Prepaid Expenses Balance Sheet item wascreated:

In 20X0, HCP pays $10MM for electric power to be delivered in 20X1. This amount is recordedby HCP as “Prepaid Rent Expense” when paid. Later, when preparing its 12/31/20X0 BalanceSheet, HCP aggregates this and all its other Prepaid 20X0 Expenses (say $21MM) into the singlePrepaid Expenses number of $31MM reported on its Balance Sheet.

From Financial Accounting’s perspective, Prepaid Expenses are assets because, if they wereconverted immediately to cash, they would bring cash to the company. For the above example,this assumes that HCP could claim a full refund for its payment, irrespective of the legalparticulars of its electricity agreement. IE: even if HCP’s legal agreement with its utility makesthe payment non-refundable, Financial Accounting still considers this payment as a Prepaid-Expense Asset) .

The rules for Financial Accounting are not usually the same as for legal constraints.(Exceptions, of course, exist). When evaluating an entity’s assets and liabilities, FinancialAccounting generally assumes that we live in a Barney-like, purple dinosaur world where entitieslove their creditors and customers, and their creditors and customers love them back. In thisworld, on 1/1/20X1, HCP could notify its utility that it didn’t want any more electricity after all,and the utility would gladly refund the amount that HCP paid for unconsumed 20X1 electricpower.

From Financial Accounting's perspective, Pre Paid Expenses are assets, because if they wereconverted immediately to cash, they would bring cash to the company, irrespective of the legalparticulars of the electricity agreement (IE: even if HCP's legal agreement with its utility makesthe payment non-refundable, Financial Accounting still considers this payment of $10MM as aPre-Paid Expense).


LONG-TERM ASSETSLong-term Assets are any assets that are not Current Assets. These generally fall into twocategories:

1. Assets that will be converted to cash, but not within a year.

Examples include long-term equity investments, and unimproved property, slated fordevelopment in several years.

2. Assets that will help generate cash over a long period of time. These include Property,Plant, and Equipment (PPE) and purchased patents.

Long-term Assets are not typically identified with a special Balance Sheet heading, as you cansee on HCP’s 20X0 statement. HCP’s 20X0 Balance Sheet includes the Long-term AssetsLong-term Investments, Land, net PPE, Goodwill, and Other Assets. Let’s examine all of these.

Long-term Investments are investments that an entity intends to hold for more than a year.Examples include:

A two-year Treasury Bond.

A three-year CD.

IBM bonds maturing in thirteen months.

Shares of GE stock that the entity has no foreseeable plans to sell.

Note that an entity may hold securities, such as shares of GE stock, as both Marketable Securitiesand Long-term Investments. The characterization of the stock will depend on the entity’s intent(IE: whether or not it plans to sell the stock within a year of the Balance Sheet date).

Land includes undeveloped and unimproved parcels. These are recorded by FinancialAccounting at cost when purchased, and normally keep this value for as long as the entity ownsthe property. If a parcel of land clearly declines in value below its purchase price, the owningentity would write-down the carrying value to the current market price. (Conversely, if theland’s price subsequently rose, the property value would not be marked back up).

Accordingly, land is said to be valued at the lower of cost or market. Its value would become anexception to the Cost Concept if/when it was marked down. So for example, after Abimelech’ssolders destroyed Shechem and sewed all the town’s land with salt (Judges 9:45), Shechem’sunlucky landowners would have to significantly mark down the value of their property holdings.

Net Property, Plant and Equipment (also Net PPE or Net Fixed Assets) includes items that aretangible, long-lived, and used to produce goods or services that generate cash inflows. “Net”acknowledges that these items are recorded at cost minus wear. (This wear is called“accumulated depreciation.” We will cover it in-detail in a future chapter). PPE not qualified as“net” usually describes the total amount paid, without considering wear incurred to the Balance


Sheet date. Examples of an entity’s PPE include: buildings it owns, machinery, trucks and cars,furniture, and some (long-lived, relatively expensive) computers.

Goodwill is created when an entity buys another company or merges with it. To understandGoodwill, we must first understand the accounting treatment of mergers.

When an acquiring entity (the acquirer) purchases a target firm, it puts the target’s accounts intosomething like Balance Sheet Valuation form. Recall how an entity’s GAAP accounts areadjusted in the Balance Sheet Valuation Method:

The method starts with:

Equity(accrual) = Assets(~cost) – Liabilities a)

Next, costs of assets are replaced with their market values, and the value of identifiable,non-GAAP assets is added.(Examples of non-GAAP assets include patents, brands, and copyrights).

After these adjustments, equation a) becomes:

Equity(Market Value) = Assets(Market Value) – Liabilities

After a purchase transaction is completed, target’s identifiable intangible assets are included inAssets(Market Value), and shown on acquirer's Balance Sheet. For example, a target company mayhave been awarded a patent. GAAP does not allow the target to place an asset value on thepatent (even though it almost certainly is valuable), but an acquirer will determine a fair marketprice for the patent when it purchases the target. After the purchase, the acquirer typicallyincludes the market price of the patent in the Intangible Assets section of its Long Term Assets.HCP’s Balance Sheet does not show any Intangible Assets, either because it has none or becausetheir value is small enough to be incorporated into the Other Assets section of its Balance sheet.Other Assets are described in detail below.

The value of the purchased patent is then amortized over the remaining useful life of the patent.Amortization recognizes “wearing out” of intangible assets, like patents, in the same way that“accumulated depreciation” accounts for the wear of tangible assets. (Some intangible assets,trademarks, brands and internet domains are assumed to be indefinitely renewable, and aretherefore unamortized).

Now we are finally ready to define Goodwill. Goodwill is defined as the price paid for the targetin excess of the target’s equity (Market Value). Mathematically:

Goodwill ≡ Price Paid for Target - Equity(target, Market Value)

Conceptually, Goodwill represents the amount paid for the target’s unidentifiable, intangibleassets. These assets may include, for example, the value of the target’s brilliant managementteam, the target’s history of reliable, high earnings growth, the firm’s consistent, industry-leadinginnovation, etc. (When evaluating firms with Goodwill, many value investors assume this assetto be worthless and set its value to zero).Goodwill is assumed to be constant forever, unless thepurchased entity loses its economic value to the purchasing company. In this case, the Goodwillvalue is marked down.


Other Assets include miscellaneous, economically-valuable stuff that an entity has not listed inany other asset category. Like Pre-Paid Assets and Notes Receivable, Other Assets may be longterm or short term. (HCP has only long-term Other Assets). An example Other Asset for HCPcould be an obsolete non-working lawn-care tractor which the company intends to sell as steelscrap.

In general, Other Assets should comprise a small amount of a company’s total assets. This isbecause, without looking at the notes accompanying an entity’s financial statements, we have noidea what the company’s Other Assets may be. Companies wishing to be transparent and helpfulto readers of its financial statements will aim to make this relatively opaque quantity small.

LIABILITIESAs noted in Chapter 1, Liabilities are obligations of an entity to make payments in the future.Liabilities include principal amounts (the amount shown on an invoice or the amount loaned by abank), plus any unpaid accruals (such as interest accrued on a bank loan). Principal amounts andinterest accruals for loans, bonds etc. are reported separately.

Liabilities may also be thought of as claims to an entity’s assets. (These claims are not usuallyagainst specific assets, but rather the whole set of an entity’s assets). The claims of liabilitiesover assets are stronger than claim to assets held by than owners’ (shareholders’), because theyarise from invoices or other contractual obligations to pay. So for example, if HCP decided toliquidate itself (or if it was forced to liquidate in bankruptcy), it would first sell its assets, andpay off all its liabilities, then pay its shareholders any leftover funds. (Usually in bankruptcy, anentity’s assets to not bring enough to fully pay off its liabilities, so shareholders are left withnothing).

Another way to think of liabilities is as any balance sheet item that, if converted to cash today,would require the entity to pay cash. This is the corollary treatment to assets that we introducedabove. As with assets, we make this consideration in our Barney-like, loving world, usuallywithout consideration of legal contract considerations.

Here is HCP’s balance sheet with Liabilities and Equity emphasized. Let’s go through theLiabilities.


CURRENT LIABILITIESAs with assets, HCP’s liabilities are separated into “Current” and “Long-term” categories.Analogous to Current Assets, Current Liabilities are those obligations that the entity expects topay off in cash within a year of the Balance Sheet date. Let’s take on each of HCP’s CurrentLiabilities:

Accounts Payable represents cash owed to suppliers (vendors) for goods or services furnishedbut not yet paid for. The Accounts Payable total is typically compiled from suppliers’ invoices.

Notes Payable includes cash owed to suppliers (vendors) or others for goods or services, whichis evidenced by formal written notes. An example is an unpaid credit card balance.

Notes typically require repayment of principal plus interest. A Note Payable liability includesonly the principal amount. Unpaid accrued interest will be separately recorded as “AccruedInterest” and reported as such, or reported in combination with other accruals as “AccruedLiabilities.”

Accrued Expenses include cash earned by virtually anybody or anything but a vendor, which hasyet to be paid. (Sometimes cash earned by vendors is included – see below). Accrued Expensesare usually not evidenced by a specific piece of paper. Examples include: Employees’ salary earned but unpaid. Taxes owed but unpaid. Interest accrued on notes and bonds

(This could include interest accrued on a note issued to a vendor).


Unearned Revenue (also “Deferred Revenue,” or “Pre-Collected Revenue”) represents servicesor goods that an entity has been paid for, but has not yet delivered. An example for HCP mightwork as follows:

On 12/30/20X0, HCP receives $60K from a doctors’ office for Q1-20X1 rent.Transaction Table entries for this event would be:+ Cash Asset $60K, + Unearned Revenue Liability $60K

The $60K is then included in the $10MM of Unearned Revenue that HCP that reportedon its 12/31/20X0 Balance Sheet.

This amount is a liability because, in our Barney-like world, if the doctors move out on1/1/20X1, HCP will have to refund this customer's 20X1 rent payment (less one day’s worth ofuse). This would be a cash outflow for HCP and therefore the Unearned Revenue is a liability.

At this point you may be wondering (if you are not half asleep) what the future of this liabilitywill be. Does it stay on HCP’s books forever, or will it be withdrawn? If it's withdrawn, how?Here is how the future of this liability could play out:

On 3/31/20X1(the end of Q1-20X1), the $60K liability is converted to Revenue (Equity), by thisTransaction Table entry:

- Unearned Revenue (Liability) $60K+ Revenue (Equity) $60K

After this entry is made, this $60K of Unearned Revenue will no longer appear on HCP’sBalance Sheet. This amount will be included as “Sales” or “Revenue” in HCP’s Q1-20X1income statement because HCP has delivered the good, and included as part of the firm’s Equityon its 3/31/20X1 Balance Sheet.

The Current Portion of Long-Term Debt includes any bonds or bank loans that will “mature”within one year of the Balance Sheet date. “Mature” means that the obligation’s principal mustbe repaid. (“Principal” is again the total amount loaned to HCP).

This account also includes any portion of a bond’s or loan’s principal that must be repaid in thenext year. For example, most mortgage loans specify that a portion of the borrowed principalmust be repaid every year, for the life of the mortgage. Most bonds, by contrast, require onlythat interest is paid each year until the bond matures, when the entire principal amount is repaidat once.

LONG-TERM LIABILITIESLong-Term Liabilities are obligations that will be paid in later than one year of the BalanceSheet date. As with Long-term Assets, they are not typically shown with their own heading.Here is a description of HCP’s Long-term Liabilities:


Long Term Debt includes any bonds or bank loans that will mature after one year of the BalanceSheet date. Any unpaid interest on these liabilities will be accounted for separately as “AccruedInterest,” and reported on HCP’s balance sheet as “Accrued Interest” or as part of “AccruedLiabilities.” In either case, interest accrued will almost certainly be a Current Liability, becausevirtually all note, loan and bond agreements call for cash interest payments to be made monthly,quarterly, semi-annually or annually. (Of course many loan sharks require weekly or even dailypayments, but they do not usually employ Financial Accounting methods).

Other Liabilities represent miscellaneous liabilities that an entity does not include in any othercategory. These may be Current, Long-term, or both. (HCP happens to have only Long-termOther Liabilities). As with Other Assets, Other Liabilities (or “Miscellaneous Liabilities”)should comprise only a small portion of an entity’s total Liabilities.

An example of HCP’s Other Liabilities is its Pension Obligations. HCP recently started aPension program for some of its youngest employees. As these employees continue to work atHCP, they earn the right to receive pension payments during their retirement (many years away).The company is obligated to make these payments when they come due.

STOCKHOLDERS’ EQUITYStockholders' Equity is also known as “Owners’ Equity”, “Book Value” or simply “Equity.”Recall that Equity is defined to be Assets minus Liabilities, and that it is also numerically equalto:

Σ PIC + Σ NI - Σ DivWhere: Σ means ‘sum over the life of the entity.’ PIC stands for “Paid in Capital” (investments by shareholders). NI = “Net Income” = Revenue – Expense. DIV is short for “Dividends” (cash payments made to the firm’s owners).

Owners Equity is typically reported on Balance Sheets in one of these three ways:

1. A single line (as on HCP’s Balance Sheet), identified as “Equity,” “Owners’ Equity,”“Shareholders’ Equity,” or “Stockholders’ Equity.”

2. Σ PIC + Σ NI – Σ Div(As shown on WEA’s Q1 Balance Sheet, and where as usualΣ NI = Σ {Revenue – Expense}).

3. Σ PIC + “Σ Retained Earnings” (or “Σ RE”), where:Σ RE ≡ Σ NI – Σ Div = Σ {Revenue – Expense} – Σ Div

The meaning of Retained Earnings is:The total Net Income (NI) earned by an entity over its life, minus the total amount paid to thecompany’s owners as dividends.


Good to Know:PIC (“Paid in Capital,” by the firm’s owners) usually represents the transfer of cash, but mayalso include the transfer of other assets to the entity. Example:Partner 2, an owner of WEA, gives the firm computers valued at $2,500, in return for his 50%ownership stake. In a Transaction Table, this event would be recorded as follows:

Δ Assets Δ Liabilities Δ Equity

PPE (computers) $2,500 $0 PIC (Partner 2) $2,500

REVENUE AND EXPENSERevenue and Expense will be covered in detail when we analyze the Income Statement in thenext chapter. However, their contributions to equity are so common and so important that wewill consider their fundamentals here.

Revenue is defined to be the sales of goods or services associated with company’s main, day-to-day business. (IE: Sales resulting from a company’s normal operating business). The mostimportant aspects of revenue are: it is recorded only after services are performed or goods are delivered. the time of recording is unrelated to when any associated cash is received. revenue does not include infrequent sales of items that are not directly associated with day-

to-day business transactions. So for example, if Apple sells its iPhone assembly plant inSingapore, the transaction would not be considered Revenue, because Apple is not in thebusiness of buying and selling smartphone assembly plants.

Expenses are defined as the costs of providing goods or services, which are associated with anentity’s main, day-to-day business operations. The key things to know about expenses are: Unlike revenues, many expenses are recorded as soon as obligations are incurred.

Inventory4-related expenses are an exception, and are booked (recorded) when theircorresponding revenue is recognized. So for example, Apple would record an office-rentexpense every month for its rented headquarters space. It would recognize costs associatedwith assembling its iPhones (which are part of the company’s inventory) when the phonesare sold

the time of recording an expense is unrelated to when associated cash is disbursed. dividends are not expenses, because they are not associated with the normal, day-to-day

operations of a company infrequently purchased items that are not directly associated with day-to-day business

transactions are also not expenses. Using another Apple example, if the company purchasedan iPhone assembly plant in Vietnam, the purchase price would not be considered anexpense, because again Apple is not in the business of buying and selling smartphoneassembly plants

4 As noted previously, Inventory is a company’s goods that are being created or waiting to besold during its day-to-day course of business.


REVENUE AND EXPENSE EXAMPLES:

1. Which is recorded as Revenue?

a) On 10/01/20XX WEA invoices client $10,000 for valuing their company.

b) On 12/01/20XX WEA receives $10,000 payment from the client.

c) On 12/01/20XX WEA invoices and receives $50,000 for the sale of its headquarters building.

2. Which is Expense?

a) On 5/01/20X1 WEA’s accountant sends the firm a complete set of 20X0 tax forms andan invoice for $500.

b) On 7/01/20XX WEA sends the accountant a check for $500.

c) On 12/01/20XX WEA signs a contract to pay $60,000 for its new headquarters building.

Solutions:1. a). 2. a).

More detailed information on a firm’s Equity is shown on the Owners’ Equity Statement (the OEStatement), which reports:ΔOE = ΔPIC + ΔNI – ΔDiv5 for one or more accounting periods.

As noted above, the Income Statement (the IS) reports:ΔNI = ΔRevenue – ΔExpense for one or more accounting periods.

We will cover these statements in Chapter 4.

NOTES ON NOTATION

So far in this text, we’ve used the “Σ” symbol to mean “sum over the life of the entity.” (IE:ΣOE = ΣPIC + ΣRE). Going forward, we will sometimes omit the summation symbol, when themeaning of an equation is clear without it. For example, we may state OE = PIC + RE, implyingthat each term represents the total amount recorded from the inception of the firm.

Similarly, we used the “Δ” to mean “changes during a period.” (IE: ΔNI = Δ {Rev – Exp}). Forthe rest of the text we may omit the Δ when its meaning is clearly implied. For example, we mayreplace the above expression NI = Rev – Exp, implying that each quantity represents the totalchange during an accounting period or periods.

5 Here “Δ” means changes in the period or periods covered.


RECORDING ACCOUNTING EVENTS

CHAPTER 4


RECORDING ACCOUNTING EVENTS:TRANSACTION TABLES

There are three common methods of recording accounting events. We will look in detailat two of these: Transaction Tables and Journal Entries. The third way to recordeconomic events, with T accounts, is less helpful than the other methods, and isparticularly ill-suited to the spreadsheet and database applications that are commonlyused in business and finance today.

TRANSACTION TABLE REVIEWWe have already taken a quick look at recording economic events with TransactionTables. Below is the Transaction Table for WEA’s first quarter of operations as preparedin Chapter 2:

Note the important properties of the table: Duality is preserved for each entry. The fundamental accounting equation applies to each entry, as shown in the headings at the

top of the table:ΔAssets = ΔLiabilities + ΔEquity,where: ΔEquity = ΔPIC + ΔNI – ΔDiv,and: ΔNI – ΔRevenue - ΔExpense

Dollar amounts and accounts recorded for each transaction.

CHAPTER4–RECORDINGACCOUNTINGEVENTS PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

As we have seen, the table’s columnar structure makes it easy to create a Balance Sheetfrom it. This structure also enables the quick formulation of Income Statements, as wewill see in the next Chapter.

EVENT RECORDING TRIGGERSThe need to record an event (in a Transaction Table or as a set of Journal Entries) is triggered bytwo types of accounting events:

1. Economic Event Triggers

An economic event trigger is something that must be reported as it happens. An examplewould be that the owners of WEA contributed $10K of PIC (Paid In Capital) to the firmduring its first quarter of operations (Q1). Usually economic-triggered events are associatedwith documentation, such as an invoice, a bond contract, or a stock certificate.

2. Statement-Preparation TriggersA statement-preparation trigger is caused by something that’s been accruing, which must benoted and included in the firm’s financial statements. The trigger is the need to prepare anew set of statements. For example: “In preparation for creating an EOQ Balance Sheet,WEA noted that its loan outstanding accrued $5K interest in the quarter.” As with moststatement-preparation triggered events, WEA has no formal document from its lenderreminding the firm of its interest accruals.

Other common statement-preparation triggers include accrued tax and accrued salary. Inthese cases, WEA again receives no documentation (no invoice or statement-of-account)reminding it of increases to these liabilities.


HCP TRANSACTION TABLE EXAMPLE

Let’s create a Transaction Table for HCP’s Q1-2010 accounting events. (Quantities shown are inthousands unless otherwise noted):

Here is additional information needed to complete some of the firm’s Transaction Tableentries:

Beginning of Period Balance Sheet(BOQ1 2010, which is the same as EOQ4 2009)


HCP’s net PPE “depreciates” (wears out) at $40,000K per quarter. The firm treats heating oil as an asset similar to PPE, which “depletes” as it is used. These accounts, not included on HCP’s BOQ Balance Sheet, will help us record certain

events:

AssetsPre-paid Expenses

LiabilitiesAccrued ExpensesDeferred Revenue

Stockholders’ EquityRevenueSalary expenseWrite-off expenseInterest expenseDividends

Below is the completed table, followed by a discussion of how the key transactions werecreated:


1. The invoice adds to Accounts Receivable, and allows HCP to declare revenue forthese already-provided services.

2. The invoice received of $10,000 increases the company’s accounts payable (AP).Receipt of the oil triggers the creation of the heating oil asset, which will be reduced(“depleted”) as the oil is used.

3. The new equipment adds to HCP’s PPE, while the obligation to pay for the equipment isacknowledged in the Note Payable liability.

Good to Know:When a firm purchases property, plant or equipment, we say that it is “capitalized” to thePPE account.

4. The electricity purchase reduces cash by $2,000 and generates a pre-paid electric expenseasset. This asset may be reported on Balance Sheets in aggregate with other pre-paidexpenses.

5. HCP’s employees do not invoice the company, so it needs to “note” its unpaid salaryliability whenever it prepares a Balance Sheet. In this case HCP records a $10,000Accrued Salary liability and recognizes the amount owed as Salary Expense. (Rememberthat most expenses are recognized as soon as they appear on an entity’s radar, irrespectiveof when they are paid off in cash).

6. Cash from HCP’s customer increases its cash account balance by $1,000. This generatesan Unearned Revenue liability because in Financial Accounting’s Barney-like world, itwould gladly refund these deposits if asked, irrespective of rental agreement legalwording.

7. Since the maturity of this piece of HCP’s debt has toggled from more than a year to ayear or less, it has to be moved from long-term debt to short-term debt.

8. The total purchase price of the sheet rock is removed from PPE, because it can no longerbe used to maintain or upgrade the HCP’s buildings. The $500 miscellanies asset isgenerated from the estimated salvage value of the resulting wet gypsum board. (Thesalvage value is the price HCP thinks it can realize for this soggy mess in the wet-gypsummarketplace). The net reduction of HCP’s assets reduces the firm’s equity by declaring a$1,500 write-off or write down expense.

9. As with HCP’s earned-but-unpaid employees’ salary, the company needs to “note” theamount of accrued-but-unpaid interest on its debt whenever it prepares a balance sheet.Recording is parallel unpaid salary: equal amounts Accrued Interest Liability and InterestExpense. The $8,262 amount is computed as:Total debt at beginning of quarter * 2.533% interest per quarter.(40,000 + 286,155.0) * 0.02533 = $8,261.5

10. Cash is reduced by $4,000, and the accompanying reduction in equity is recorded as aDividend.


11. Paying the employees reduces cash by $5,000. Once the employees are paid, HCP nolonger has a related future obligation, so its Accrued Salary liability must be reduced bythe same amount. (Recall again that recognizing the need to pay as an equity-reducingexpense is unrelated to the timing of this cash flow).

12. Paying for a portion of its heating oil reduces HCP’s cash by $5,000. HCP no longer hasa related future obligation to pay this amount, so its Accounts Payable liability must bereduced by the same amount. (Note that this payment has no effect on HCP’s Heating OilAsset).

13. Cash in the door increases the balance of HCP’s cash account by $10,000. Since HCP’stenants no longer owe this amount, the company must reduce its Accounts Payable by theamount received.

14. The $40,000 of net PPE depreciation (wear) directly reduces net PPE by this amount.This also represents a reduction in equity, which is acknowledged in the DepreciationExpense entry.

15. Half of the heating oil is gone, so the value of the heating oil asset is reduced by 50%($5,000). This depletion, like depreciation, represents a reduction in HCP’s equity and isrecorded as Depletion Expense.


WHY CREATE TRANSACTION TABLES?

There are at least two important reasons for creating Transaction Tables:

1. To understand financial implications of a company’s actionsIn HCP’s case, our Transaction Table shows, for example, that the company’s debt generatesan interest expense of $8,262K per quarter. This shows that HCP must earn $8.3MM perquarter to cover its debt obligations before it can put income toward bolstering its economicsustainability by, for example, expanding or upgrading its facilities.

Enquiring minds might wonder how HCP could change this situation. One ideawould be for HCP to issue more shares of stock and use the proceeds to pay off someof its debt. This would reduce the firm’s required interest payments. We will explorethe benefits and drawbacks of this approach (and other possibilities) in futurechapters.

2. To create new financial statementsBoth Transaction Tables and journal entries provide firms with data required toprepare financial statements. If a firm has maintained a history of all its transactionssince inception, nothing else is needed to make a new Balance Sheet, Income, CashFlow or Owners’ Equity statement.

HCP BALANCE SHEET EXAMPLE

Software packages like Quickbooks and AccountingBasics tm create financial statements bydrawing on an entity’s complete, from-inception database of accounting transactions. Forlearning purposes and for creating models used by investment banks, private equity firms andinvestment analysts, its easier and quicker to create new financial statements from an entity’smost recent statements, plus all its Transaction Table or journal entries recorded in its mostrecent accounting period (whether monthly, quarterly, annually, or etc). Let’s use the aboveTransaction Table for HCP and its BOQ1-2010 Balance Sheet to create the firm’s EOQ1-2010Balance Sheet:

Step 1: Organize the Transaction Table entries by account.

Sort all the Transaction Table entries by account, as shown below. Don’t worry about scramblingthe dates – the balance sheet is all about totals, so individual event dates do not matter. Here isHCP’s sorted table:


Step 2: Add Beginning of Period balances (BOP balances).

For each account, add the BOP balance (taken from last period’s Balance Sheet) to the totalchanges incurred during the period. Include BOP balances for accounts whose values did notchange during the period. This addition produces the total, since-inception total for eachaccount. As you can see, this step is consistent with the fundamental accounting equation:

The cash amount for HCP’s EOP Balance Sheet is computed as:EOP Q1 cash = $151,862 - $5,000 = $146,862


Similarly, the accounts payable for HCP’s balance sheet is:EOP Q1 accounts payable = $108,000 + $5,000 = $113,000

Step 3: Organize the result in Balance Sheet format.

Here is the completed Balance Sheet:

As shown, Balance Sheet format has several key features:

The report’s titling includes the fact that it is a balance sheet, the units displayed, and theperiod covered. (Balance Sheets are always prepared as-of the ending moment of theperiod).

Only account totals are shown, not individual changes incurred during the period.

Subtotals include (at lease) assets, liabilities, equity and liabilities plus equity.

The fundamental accounting equation is satisfied.IE: Total Assets(EOP) = Total Liabilities(EOP) + Total Equity(EOP)

Speed Learning Tip:You should check that you can reproduce this complete Balance Sheet on your own.


ACCOUNTING CONCEPTS

Let’s sprinkle in another accounting concept. Here again is our list of concepts, with theAccounting Period highlighted.

1. Accrual2. Money Measurement3. Duality4. Entity5. Going Concern6. Cost7. Accounting Period8. Conservatism9. Realization10. Matching11. Consistency12. Materiality

The Accounting Period concept says several things: Financial statements are to be prepared at regular intervals, covering regular time periods.

IE: a firm may choose to prepare statements on a monthly, quarterly or annual basis, but itshould not prepare monthly statements for January followed by bi-monthly statementscovering February and March.

An entity’s fiscal year-end does not need to coincide with calendar year-end. Some retailcompanies, for example, set their year-end as January 31 to help capture all of its winterholiday sales and expenses in its fiscal 4th quarter.

Snapshot reports (IE: Balance Sheets) are prepared as of the end of each period. This isconsistent with the balance sheets we have already reviewed and prepared.

Flow reports (IE: Income Statements, Owners’ Equity Statements and Cash FlowStatements) cover one or more periods. So for example, a company that reports quarterlymay provide a quarterly income statement for the first quarter of the year, and an incomestatement covering its first two quarters of operations at the end of its second quarter. Thissaid, most companies that report quarterly also create flow reports that cover just onequarter.

Good to Know:Flow reports covering more than one quarter can easily be created by adding quarterly flows.You should be comfortable with this fact, as well as why it is true. You should also be able tocreate, for example, an entity’s Q2 income statement from its Q1 statement and its incomestatement from the first six months of its fiscal year.


RECORDING ACCOUNTING EVENTS:JOURNAL ENTRIES

OVERVIEWJournal entries are simply a list of accounting transactions generated from events. For eachtransaction, a journal entry:

Records dollar amounts, accounts and “A”, “L”, or “E,” status for assets, liabilities orequity respectively.

Ensures that duality is preserved. Ensures that the fundamental accounting equation is satisfied:

Δ Assets = Δ Liabilities + Δ Equity,Where as usual, Δ Equity = Δ (PIC + NI + Div), and Δ NI = Δ (Revenue – Expense).

The good news about journal entries is that they are quick to record, and are great forunderstanding the implications of an economic event. Unfortunately, it is relatively tedious tocreate financial statements from them.

Journal Entries with an Algebraic Sign ConventionCreating journal entries with an algebraic sign convention is relatively straightforward.Lets see how they work by creating a journal for several of HCP’s Q1-2010 micro-economic events:

Here is a journal for the above events:

Q1 Journal – HCP

No. Transaction

1. + $10,000 Accounts Receivable (A) + $10,000 Revenue (E)

2. + $10,000 Heating Oil (A) + $10,000 Accounts Payable (L)

3. + $3,000 PPE (A)


+ $3,000 Notes Payable (L)

4. + $2,000 Prepaid Expenses (A) - $2,000 Cash (A)

When HCP invoices its tenants, we simply record an addition to Accounts Receivable (AR) of$10,000 and a matching increase in Revenue of the same amount. By denoting the AR with an“(A)” and Revenue with an “(E),” we remind ourselves of the classification of these accountsand make it easy to check that the fundamental accounting equation,

Δ Assets = Δ Liabilities + Δ Equity

is satisfied. The completed journal entry for this event provides as much information as aTransaction Table entry, in a more compact, list-style form.

The other three journal entries work similarly. You should be sure that you can create them fromthe above list of economic events.

Journal Entries using the debit (dr) / credit (cr)Sign ConventionFor better or worst, the algebraic sign convention for journal entries is not used ascommonly as the debit (dr) / credit (cr) sign convention. Here’s how the dr / cr signconvention works:

Additions to Assets are assigned a dr (debit) “sign.”Reductions in Assets are assigned a cr (credit) “sign.”

Additions to Liabilities and Equity are assigned a cr “sign.”Reductions in Liabilities and Equity are assigned a dr “sign.”

Using mathematical shorthand we can say:+ Δ(Assets) → drand

+ Δ(Liabilities or Equity) → cr.

Note that the fundamental accounting equation still holds for every transaction. In dr/cr terms,the fundamental accounting equation becomes:

Σdr = Σcr, for every transaction.

Also note that “debit” (dr) and “credit” (cr) have no special meanings beyond their role in thissign convention. There is nothing inherently good or bad about debits or credits. The wordsthemselves could be replaced with, for example, “quarks” and “muons” without changing theirfunctionality in accrual accounting.


Let’s see exactly how the dr, cr sign convention works by creating journal entries for HCP’s firstfour Q1 events.

Here is a set of dr/cr journal entries for these events:

The journal entries are identical to those produced previously, except that the algebraic signscarried by each number have been replaced with their dr/cr counterparts.

Good to Know:Because the use of journal entries with the dr/cr sign convention is so common, we willuse this system in many examples going forward. You should become comfortable withthis system, as well as the Transaction Table method of recording an entity’s economicevents.

EXAMPLE: USING JOURNAL ENTRIES TO UNDERSTAND THE

IMPLICATIONS OF EVENTS

Journal entries help us quickly understand economic events without creating new financialstatements. Let’s consider an example at WEA:

Suppose that, a day after EOQ-1, Partner A buys out Partner B for $6K cash, paying witha $6K loan taken out by WEA. Let’s analyze the implications for WEA’s Balance Sheet


without creating a new one.

Recall WEA’s EOQ-1 Balance Sheet:

Now let’s create journal entries for the Partner B buyout:

1. Take out the loan:dr Cash (A) $6Kcr Loan payable (L) $6K

2. Pay Partner B:dr Paid In Capital (E) $6Kcr Cash (A) $6K

Note that the net effect of these two events is:

dr Paid in capital (E) $6Kcr Loan payable (L) $6K

With this simplification, the net effects of the buyout on WEA are clear:

Assets are unchanged (because cash was debited when the firm took out the loan, thenimmediately credited when the loan amount was paid to Partner B.)

The firm’s debt of the firm has increased by the amount of the loan and the firm’s equity hasbeen reduced by an equal amount.

This type of transaction is called a “Debt/Equity swap.” It is the type of thing that private equityfirms do routinely as part of a “Leveraged Buyout.”

Interestingly, private equity firms don’t often make such a clean swap. In the WEA case forexample, a typical private equity firm might take out a loan for $8K, pay off Partner B for $6K,


and issue the remaining $2K to themselves as a “special dividend.” This is clearly good work ifyou can get it.

It’s also interesting to consider what the buyout does to WEA’s financial risk. By adding to itsdebt, the firm increases its contractual obligations. This debt, unlike PIC (Paid in Capital), mustbe repaid. So, by taking out a new loan, WEA has increased its risk of bankruptcy. If the firmhas several bad operating quarters, it may find itself unable to pay interest or principal on itsloan, and be forced into bankruptcy by the lender.

In contrast to sourcing funds via debt, an entity may raise funds from shareholders(recorded as PIC) with relatively little financial risk. Unlike bank lenders andbondholders, shareholders give a firm cash in return for nothing except some shares ofstock (representing some percentage of ownership), the hope that the stock’s value willrise over time and the company may pay dividends to its shareholders in the future.Unlike loan interest and principal payments, entities are under no contractual obligationto pay dividends to their shareholders.


TIMING OF REVENUE AND EXPENSERECOGNITION

One of the most important facets of accrual accounting is the recognition of revenues andexpenses when they appear on the microeconomic radar, irrespective of when associated cashamounts are received or paid.

REVENUE RECOGNITIONUnder accrual accounting, revenue may be recognized before, when or after cash is collected.Let’s consider examples for each case:

1. Revenue is recognized before cash is collected.

At time a), WEA values a company for a client and issues a $25,000 invoice. At some latertime b),WEA receives a $25,000 check from the customer.

The journal entries for this set of events are as follows:

a) dr Accounts receivable (A) $25Kcr Revenue (E) $25K

b) dr Cash (A) $25K cr Accounts receivable (A) $25K

The revenue is recognized when the invoice is issued, and this generates a short-term asset(Accounts Receivable), which is expired later, when cash is received from the customer.

2. Revenue is recognized when cash is collected.

Upon valuing a company for a client at time a), WEA issues an invoice and immediatelyreceives a $25,000 check for the work. In this case, the journal entries are:

a) dr Cash (A) $25K cr Revenue (A) $25K

Here that there is no need for the Accounts Receivable asset, because cash is received whenrevenue is declared.

3. Revenue is recognized after cash is collected.

Consider this series of events, occurring at times a), b), and c):a) A customer gives WEA $20K as a deposit for a financial plan to be delivered next

month (sales price $25K).b) WEA delivers the plan and invoices the client for $5K.c) The customer pays $5K.


Here are the journal entries for these events:a) dr Cash (A) $20K

cr Unearned Revenue (L) $20K

b) dr Accounts Receivable (A) $5Kdr Unearned Revenue (L) $20Kcr Revenue (E) $20K

c) dr Cash (A) $5Kcr Revenue (E) $5K

In this case, the deposit creates a short-term liability (Unearned Revenue – which would result inan outflow of cash if WEA did not deliver the plan in the future). The liability is expired(reversed) when the plan is delivered. The remaining portions of events b) and c) followExample 1.

EXPENSE RECOGNITIONLike revenue, expenses may also be recognized before, when or after cash is dispersed. Let’sconsider each case:

1. Expense incurred before cash is dispersed.

a) On 7/31/2008, WEA is preparing its monthly financial statements, and notes that it hasnot paid its $1,000 July office rent.

b) On 8/5/2008, WEA writes rent check for $1,000.

Journal entries for these events are:a) dr Rent (expense, E) $1K

cr Accounts Payable (L) $1K

b) dr Accounts Payable (L) $1Kcr Cash (A) $1K

At time a), rent expense is debited because the entity has to recognize this reduction inequity regardless of whether it has paid its rent or not. Because WEA did not pay when theexpense was recognized, the firm establishes an Accounts Payable entry, to show that thisobligation will be paid off in the future. At time b), WEA pays its rent and reverses theAccounts payable liability.

2. Expense recognized when cash is dispersed.

On 7/31/2008, WEA pays its $1K for July office rent.

In this case, the journal entries are:


a) dr Rent (E) $1Kcr Cash (A) $1K

There is no need for the accounts payable liability, because WEA’s landlord is paid at thesame time the rent expense is declared.

3. Expense incurred after cash is dispersed.

Consider the following series of events:

a) On 7/31/2008, WEA has already paid (and recorded) July rent, and pays its $1,000August rent.

b) On 8/30/2008, WEA prepares financial statements for the month of August.

The journal entries for these events are:

a) dr Prepaid Expense (A) $1Kcr Cash (A) $1K

b) dr Rent (E) $1Kcr Prepaid Expense (A) $1K

In this case, WEA pays its rent before it is due. This is reflected by recording the PrepaidExpense asset. Prepaid Expense is an asset because WEA could get its cash refunded on 8/1by subletting the space or moving out and asking the landlord for a refund. (As always, weignore any legal ramifications or restrictions when considering this event from anaccounting perspective). Rent expense is not recognized until time b), when the PrepaidExpense asset is expired.


APPENDIX:TRANSACTION TABLE FOR HCP'S Q1-2010 EVENTS


CASE STUDY:THE COLLAPSE OF FANNIE MAE

CHAPTER 5

THECOLLAPSEOFFANNIEMAE.CHAPTER5 PAGE1Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

Fannie Mae (FNM) is a company chartered (originated or birthed) by an act of Congress to servea public good, which has the shareholder ownership structure of a publicly-traded commercialcompany. This type of firm is called a “Government Sponsored Entity” or GSE. OtherGSEs include Freddie Mac, Farmer Mac, Farm Credit Banks, the Resolution FundingCorporation and others.

Traditionally, FNM made money as follows. It would:

Raise (say) $100BB in cash from bank loans and bond issuance. As a GSE supposedlydoing safe, for-the-public-good business, FNM would get a great interest rate on theseborrowings – lets say 3% per year.

Use this cash to buy $100BB in mortgages from “mortgage originators” and “mortgageaggregators.” (Originators are the folks who actually offer homebuyers a mortgage loan.Aggregators purchase mortgages from originators, usually with the intent to sell them inlarge blocks to firms like FNM). The average interest rate paid by the mortgage borrowers(homeowners) would be about 6% per year when FNM was borrowing at 3%.

Enjoy receiving about twice as much interest from the mortgages it purchased than theinterest it had to pay to its borrowers. FNM would receive a bit less than 6% from themortgages it purchased (say 5.9%) because some mortgage borrowers would make latepayments or default on their loans. So per year, FNM might make $2.9BB from the $100BBof its mortgages, computed as follows:

$100BB * (0.059 – 0.030) = $2.9BB/yr

This looks like a great business model! Simply borrow $100BB or so at super-low interest rates,buy $100BB of mortgages that pay interest at twice your borrowing rate, put your feet up andwatch the billions roll in! This strategy was in fact great for FNM until mortgage defaults starteddramatically increasing in 2007 and 2008. During this period FNM got into big financial troubleand ultimately went bust (or at least as bust as possible for a GSE). Here is how it played out:

As 2008 wore on and the number of mortgage defaults steadily climbed, FNM's lenders –including Goldman Sachs, JP Morgan, hedge funds, pension funds and others –suspected thatFNM was overvaluing its mortgages. For example, some analysts may have assumed thatFNM's mortgage assets were worth 10% less than their reported values on the company's balancesheet. The consequences are shown in the following Balance Sheets and journal entries:


To get from FNM's “Accrual Accounting” (As-Reported) 6/30/08 Balance Sheet to the “TrueValue” Balance Sheet, the company's mortgage assets would be simply written down by 10%, asshown in the “Minus BS” column. IE:cr Mortgages $77,414,500

dr Mortgage write down expense $77,414,500

The effect of the writedown, as seen in the “True Market Value” Balance Sheet, is to reduceFNM's 'true-value' equity to -$36,188,500. If the analyst's assessment was correct, the true valueof FNM's assets was less than the for-certain value of its liabilities by this amount. As most ofFNM's liabilities were loans and bonds, this implied that FNM would be unable to repay its loanand bond obligations as they matured.

As lenders started to believe that analyses like the one above represented FNM's actual situation,they stopped taking on new debt of FNM, and tried to sell the FNM loans and bonds they owned.

At this time in 2008, FNM either owned or guaranteed about 40% of all the mortgages in theU.S. Because of this extraordinary involvement in the mortgage market, decision makers in thefederal government came to believe that if FNM collapsed, the turmoil in the mortgage marketwould be huge, and might help propel the country into a very deep recession or depression.


Treasury Secretary Henry Paulson (pictured) then decided the government should step in to avertthis potential disaster. Over the weekend of September 6-7 2008, the federal government putFNM into receivership, and soon after announced that the Treasury Department would providethe company with enough cash to pay off pay off its debts and continue operating indefinitely.

The details of this government bailout were as follows:

The government would immediately give FNM (say) $40,000MM, making the firm's equityworth more than zero.

In return, the government would receive “preferred stock” in FNM, with these features. Thepreferred shares would:

Have a higher claim on FNM’s assets than the claims of existing “common equity”shareholders.

Have no voting rights. (The lack of voting rights would help fight off claims that thebailout was really a socialist takeover of the firm).

Include a mandatory dividend.

Require that all outstanding preferred dividends be paid and all preferred shares berepurchased by FNM before the entity could issue dividends to common shareholders orrepurchase its common stock shares.

The government pledged to put in as much additional cash as necessary to ensure thecontinuing operation of FNM. The government would receive additional preferred stockwith each new cash injection.

Here is a set of Balance Sheets and journal entries for an initial, $40MM cash infusion:


The cash injection restored FNM to a positive equity position (of $3,822,500K), and changed itsequity structure. The journal entries for the infusion are:

dr Cash (A) $40,000,000K

cr PIC (preferred equity) (E) $40,000,000K

As a result of the government's cash infusion and its stated commitment to financially supportFNM in the future, lenders began to believe that any cash lent to FNM would be repaid, withappropriate interest. As a result, some of them resumed doing business with the firm. Moreimportantly, a possible depression-precitipating collapse of FNM's operations was averted. Infact, FNM did so well after the bailout that by September 2009 that it either owned or guaranteed70% (!) of all residential American mortgages.

Although FNM's lenders, mortgage market participants and the U.S. economy benefited from thebailout, the firm's existing shareholders were not as fortunate. The features of the government'spreferred-shares – specifying that common stock holders could receive no benefits until thepreferred-share dividends were paid up and the preferred shares themselves were repurchased byFNM – effectively made the value of the company's common stock almost worthless.


As the chart shows, FNM's common share price dropped by more than 90% after the TreasuryDepartment announced the terms of its conservatorship/bailout deal.


INCOME, OWNERS’ EQUITY

AND CASH FLOW STATEMENTS

CHAPTER 6

CHAPTER6–INCOME,OWNERS’EQUITYANDCASHFLOWSTATEMENTS PAGE1Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

Before jumping back into the consideration of financial statements, let's cover a couple moreaccounting concepts – Conservatism and Realization.

The Conservatism Concept says three things:

a) When appropriate, reduce the value ofassets from cost (or cost minus wear) tomarket value. Recall that this is how wetreated HCP’s destroyed sheet rock.

b) Recognize only revenues and additions toequity that are reasonably certain.

c) Recognize all expenses and liabilities thatare reasonably possible.

Accounting Concepts1. Accrual.2. Money measurement.3. Duality.4. Entity.5. Going concern.6. Cost.7. Accounting period.8. Conservatism.9. Realization.10. Matching.11. Consistency.12. Materiality.

Important things to note about the first statement include:

Determining when its “appropriate” to mark down the value of an asset is non-trivial, andsometimes the source of disagreement between a company and its auditors or potentialinvestors.

The value of an asset is generally not “written up.” Exceptions include assets that weremistakenly recorded at the wrong value and assets that are always “marked to market,” suchas cash invested in money market funds or another entity's publicly traded stock.

Examples:What should the items listed in a) and b) be valued at?

a) Dole's farmland in Hawaii, purchased in 1939 for $1,000 per acre but worth about$10,000/acre today.

b) Centex's homes for sale in South-Florida. Centex is a publicly-traded homebuildingcompany, with ticker symbol CTX). In 20X0, the company built 100 South-Florida homes at acost of $400,000 each. In 20X1, Centex sold only 5 of the homes, at about $300,000 each.

For item c), determine the amount of revenue to be recorded.

c) WEA’s Assets Under Management fee for its Protect and Grow – HY investment product is1.0% per year. Because 20X0 was a bad year, WEA invoiced just $5,000 to a client with $1MMunder management.

Solutions:a) $1,000 per acre. This example reminds us that accrual accounting value does not necessarilyrepresent economic value.


b) $300,000 each. The market is clearly telling CTX that its homes are worth $300,000,irrespective of the company's cost to build these structures.

c) $5,000. Regardless of what WEA was contractually able to bill, accrual accounting onlyrecords what was actually invoices.

The Realization Concept says to recognize revenue when products or services are delivered (andnot before).

For example, HCP recognizes monthly rental revenue at the end of each month, after its space-offering service is complete for the month. Similarly, WEA recognizes revenue on deliveringinvoices and Apple recognizes revenue on delivering iPhones.


THE INCOME STATEMENTNow let's return to our analysis of financial statements (accounting reports). Recall our bullet-point summary of the four major statements and their purposes. The Balance Sheet is shown ingray, as we have already covered it. Next up is the Income Statement, highlighted in red:

Balance Sheet:

Reports financial assets, liabilities (obligations) and equity at a single point in time.

Is a snapshot report, (showing levels of assets, liabilities and equity).

Income Statement:

Shows changes in equity caused by firm’s day-to-day business operations.

It’s a flow report, showing movement of some cash and accruals over a period of time.

Statement of Owners’ Equity:

Shows details of other changes to equity over time.

It’s also a flow report.

Statement of Cash Flows:

Reports the flow of cash only over a period of time.

Sorts these movements into operating, investing, and financing buckets.

Like the Income and Owner’s Equity statements, it’s also a flow report, making the BalanceSheet our only snapshot or level report.

As noted above, the Income Statement's mission in life is to show changes in equity in anaccounting period or periods, which result from a firm's day-to-day, normal business operations.Accordingly, the only accounting events incorporated into Income Statements are revenues andexpenses. (Recall all changes in equity include ΔNI, ΔPIC, and ΔDIV, whereΔNI = ΔRevenues – ΔExpenses).

The most basic form of an Income Statement is:

ΔRevenues – ΔExpenses = ΔNet Income (ΔNI), or

Revenues (in the period) – Expenses (in the period) = Net Income (for the period).

By convention, revenues are usually grouped into one or several items, such as simply“Revenue,” or “Consulting Revenue” and Product Sales Revenue.” Expenses, by contrast, are


usually listed by individual account. As we have seen with Balance Sheets, similar expenseaccounts are often aggregated on Income Statements. So for example, electric power and waterexpenses may be reported together as “Utility Expenses.”

Income statements often include subtotals, such as “Earnings Before Tax” (EBT) or “Earningsbefore Interest and Tax” (EBIT). We will discuss the utility of these numbers as we create andanalyze example statements.

As we've previously noted, revenues represent sales of goods or services, associated with thenormal business of a company, or with the day to day operations of a company. It also good tounderstand revenues as increases in equity that result from a firm's normal business sales.

Similarly, we've described expenses as the costs of providing goods or services, associated withthe normal business of company (or the day to day operations of the company). Expenses can(and should) also be thought of as reductions to equity associated with an entity's normalbusiness operations.

Don't forget that paid in capital is not revenue and dividends are not expenses. Neither of theseevents are associated with normal, day-to-day operations. Likewise, the purchase or sale of PPEis not represented on a firm's Income Statement unless the entity's main business is trading inbuildings or equipment. (A small exception sometimes exists for a sale of PPE when a “gain onsale” or “loss on sale” is incurred. Gain/loss on sale will be covered later in a later chapter).

Let's use WEA's Q1 Transaction Table to create an Income Statement for its first quarter ofoperations. Recall the Table:


Our first step in creating an Income Statement is to focus exclusively on changes in equitycaused by WEA's day-to-day business. (IE: changes in equity from revenues and expenses):

Next we simply subtotal the remaining items by account, subtract expenses from revenue to yieldnet income, and prettify the result. This yields the completed Income Statement:

Income Statement For period: Q1 2002West End Advisors, LLC $USD UON1

Revenue $8,000Salary Expense $3,000Rent Expense $1,000Net Income $4,000

Note that the expenses hold positive signs. This is the normal convention for IncomeStatements. By contrast, all the other major financial statements use an algebraic signconvention.

Note also that there is no tax line on the Statement. As an LLC, WEA pays no income tax andtherefore incurs no income tax expense.

INCOME STATEMENT FOR HCPNow let's create an Income Statement for HCP's Q1 of 20X1, which will be more realistic andcomplicated than WEA's Q1 Statement. Recall HCP’s Q1-20X1 economic events:

1 “UON” stands for “Unless Otherwise Noted.”


Here is a list of journal entries for these events:


Speed Learning Tip:Create the above list of journal entries from the associated economic events.

The first step in creating an Income Statement from journal entries is to hunt through the list toflag all the revenues and expenses. This is a bit more tedious than scanning the equity column ofa Transaction Table, but journal entries are so common that we should be comfortable workingwith them.

Here are HCP's journals with revenues highlighted in green, expenses in yellow, and otherchanges to equity (that will not make it onto the Income Statement) in gray:


Now, as with WEA, we create HCP's Income Statement by simply subtotaling expenses byaccount, subtracting total expenses from revenue to yield net income, and prettify the result.This yields the completed Income Statement:

Income Statement For period: Q1 2010Health Care Properties (HCP) ($000 UON)

Revenue $10,000Expenses: Salary $10,000 Depreciation $40,000 Depletion $5,000 PPE write off $1,500 Interest $8,262Net Income (loss) ($54,762)


As with WEA, we've used the Income Statement convention that expenses carry a positive sign.Also like WEA, HCP does not pay income tax and therefore has no tax expense. REITs likeHCP are able to avoid paying income tax if they distribute at least 90% of their net income totheir owners as dividends. LLCs and their cousins, S-Corporations, pay no income taxirrespective of their net income “payouts” to their owners.

What HCP's Income Statement Does and Does not Tell Us.So much for the mechanics of Income Statement creation and formatting. Let's explore why wecare about Income Statements in the first place:

Income Statements enable corporate officials, investors and potential investors to suss outinteresting insights about a firm's operations. In HCP's case, for example, we see:

1. In Q1, expenses outran revenues by $54.8MM2. The firm's salary expense was equal to 100% of its revenues, leaving nothing to meet

other expenses.3. HCP's interest expense totaled 83% of revenues for the quarter.4. Depreciation expense was very high, coming in at 4 times sales.5. PPE had to be written off.

The first four insights tell us that HCP's operations are not sustainable at this level of revenue.IE: it may soon be in danger of going bankrupt because its day-to-day business expenditures areso much greater than its normal operating inflows of cash and accruals. The fifth insightsuggests that the firm's management may be poor, or its managers are subject to bad luck.

This brings us to what HCP's Income Statement leaves out. Why did the firm have to write offsome PPE? Did a poor decision by management result in the destruction of some equipment?Was the firm subject to an unusual and unexpected natural disaster such as Hurricane Sandy?

Here are some other important questions that the Income Statement raises but leavesunanswered:

1. Was this quarter's operations an anomaly, or part of an inexorable slide into financial oblivion?

2. If the quarter's poor operating performance was anomalous, was problem caused by a dropin sales or an increase in expenses?

3. How did HCP’s performance compare to its competitors in the quarter?4. How much of HCP's expenses were paid in cash? And how much cash and borrowing

capacity does the firm have in reserve?

Answers to most of these questions can be found reviewing HCP's:

§ Historical Income Statements.These would answer whether or not this quarter's performance was anomalous.


§ Income Statements (ISs) of comparable companies (often called “comps”).Comp's ISs would tell us how HCP's financial performance relates to other entities in itsindustry.

§ “Notes to Financial Statements.” These notes are considered to be part of any set offinancial statements, although in this text we will usually omit them.HCP's Notes should explain the reason for its PPE writeoff.

§ Other financial statements.HCP's Cash Flow Statement, for example, would show how much of HCP's expenseswere paid in cash during the quarter.

INCOME STATEMENT REFINEMENTSIncome Statements are often refined by the addition of subtotals. One of the most common anduseful is “EBIT,” or Earnings Before Interest and Taxes.

EBIT aims to show an entity's earnings generated by its day-to-day business operations, withoutconsideration of its financing obligations or tax status. It is used, for example, to evaluateregional managers, who have no control over the company's tax rate, or corporate-level decisionsto take out or pay down loans. These facts make EBIT a more appropriate performance-evaluation tool for managers than Net Income (NI).

A quick review of HCP's Income Statement shows that its Q1-2010 EBIT was -$46,500K. Hereis the firm's complete IS with EBIT subtotaled:


OWNERS’ EQUITY STATEMENT (OES)The Owners' Equity Statement (OES) is, like the Income Statement, dedicated to reportingchanges in equity over one or more accounting periods. The OES focuses on reporting equitychanges that are not detailed on the income statement, particularly changes in Paid in Capital(ΔPIC) and Dividends (ΔDIV).

The OES shows transaction-level changes to the PIC and DIV portions of equity, but Income-Statement-related changes are summarized only by a single Net Income entry. (The revenues andexpenses from which Net Income is derived are of course detailed on the Income Statement).OESs are the only financial reports to show transaction-level detail. IE: if an entity issues twostock sales in a quarter, the period's OES will show two PIC entries. This contrasts with all otherfinancial reports, where individual changes to specific accounts are subtotaled and reported as asingle number.

OESs are flow reports, and satisfy this “roll forward” or “flow” equation:

EquityBOP + ΔNI + ΔPIC - ΔDIV = EquityEOP

They are organized in a spreadsheet-like format as show below, with equity accounts listed ascolumns, and individual rows for each equity-changing economic event.

As with many spreadsheets, rows and columns are typically totaled, with a grand total shown inthe right-lowermost corner of the table.

OWNERS’ EQUITY STATEMENT EXAMPLELet's create an Owners' Equity Statement for WEA's first quarter of operations, using thecompany's Q1 journal entries shown below. Note that WEA's buyout of Partner 2 has been putinto Q1 for this exercise.


Our first step in creating the OES is to identity all journal entries that change equity, as shown:


The Income Statement items are highlighted in orange because they will be aggregated into NetIncome = $4,000.

Next we build the OES statement, using one row for Net Income and one row for each additionalchange to equity:


Notes on the Statement:1. The entity name and accounting period are as-always included at the top of the report.2. WEA's BOP balances are zero because the firm started operations in this period. In

subsequent periods the BOP balances could be pulled from the prior period's OES.3. The row and column totals are both equal to $6,000, as shown in the lower-right entry of the

table. This entry also matches the EOP equity reported on WEA's Q1 Balance Sheet.


PERCENT OWNERSHIP VS SHARE OWNERSHIPAs we know, one can become a part owner of an entity by providing the firm with cash (or otherassets) in return for an ownership stake. Such transactions are recorded as Paid in Capital (PIC).

Firms may measure ownership in one of two ways:

1. By keeping track of what percentage of the firm is claimed by each owner. This is calledpercentage ownership. An example PIC transaction would be “Partner 1 gave $5K to the firmfor a 50% ownership stake” (see journal entry of 6/18/2002 in table above).

2. By issuing shares of stock, each of which indirectly represents a fixed percentage ownershipof the firm. This is called share Ownership. An example would be “Mr. HotInvestor purchased1,000 shares of the company for $20,000. At the time, the firm had 10,000 shares outstanding.”Here we compute HotInvestor's percentage ownership as 10% = 1,000/10,000.

LLCs may choose to measure ownership by either method. C-Corporations, which includealmost all publicly traded companies, must use the Share Ownership method.

Share ownership makes it easy for a company to change its population of owners without PICtransactions. For example, if the above company above has chosen to make its sharestransferable, then Mr. HotInvestor may transfer his ownership stake to Ms. WarmInvestor bysimply selling his shares to her. This is in fact how the ownership of most publicly-tradedcompanies changes continuously throughout the day without any PIC events.

While we are on the subject of ownership transfers, this is a good time to reinforce theimplications of +PIC and -PIC transactions. +PIC transactions (positive PIC transaction)represent an entity's receiving cash or other assets in return for awarding someone or some entityan ownership stake. The entity's equity of course increases through such an event. Similarly,-PIC transactions (negative PIC transactions) represent an entity's paying cash to owners inreturn for the relinquishment of their ownership stake. The firm's equity is reduced throughthese events.

Negative PIC transactions are called “buybacks” or “buyouts”. Participating owners' stakes arereduced by surrendering their % ownership (in Percentage Ownership situations) or bysurrendering their shares (in Share Ownership situations). Surrendered shares are deemed to beretired, expired or expunged, and not longer count toward a firm's total shares outstanding. (Agood way to remember this is to think of an owner delivering her physical share certificates tothe company incinerator, where they are vaporized and, in return, she receives a bag of cash fromthe firm's CFO).


CASH FLOW STATEMENT (CFS)As we know, the Cash Flow Statement (CFS) reports all of an entity's cash flows over anaccounting period or periods. Cash flow reports include physical bills and cash held in any“demand deposit” account, from which cash can be withdrawn at any time without incurring apenalty or risk of principal loss. Such accounts include checking balances and money marketfunds, but not certificates of deposit (CDs) or short-term Treasury notes.2

CFSs satisfy the roll-forward or flow equation:

CashBOP + ΔCash = CashEOP

BOP and EOP balances must, as usual, match their corresponding Balance Sheet entries.

The three cash flow categories are detailed as follows:

1. Cash Flows from Operations (Operating Cash Flows, OCF)The Operating section of the CFS includes all Income Statement-related flows. Thisincludes, for example:i) Any cash flowing in or out from the day-to-day production and sale of products or

services, such as:

§ Paying for inventory

§ Receiving cash from product or service sales

§ Paying suppliers and employees' salariesii) Other Income-Statement-related flows, such as:

§ Paying or receiving loan interest

§ Paying income taxes

Good to Know:Consider an entity that has no Income Statement-related accruals in a period. IE: all revenue iscollected in cash when sales are declared, and all expenses are paid when invoiced or noted. Inthis case, the Operating portion of the firm's Cash Flow Statement will look just like its IncomeStatement. Similarly, for any entity that uses Cash Accounting instead of Accrual Accounting,the Operating portion of the firm's Cash Flow Statement will be the same as its IncomeStatement.

2. Cash flows from Investing (Investing Cash Flows)

Investing Cash Flows include any non-operating cash flow to or from a 3rd party, which isassociated with the investment of a firm’s resources. Examples include:

§ Purchase or sale of Property, Plant and Equipment (PPE)These transactions are called “net Capital Expenditures” or “net CAPX”.

2 CD's are excluded because they have an early-redemption penalty feature, and Treasury notes are excludedbecause their principal may only be redeemed on their maturity date.


§ The purchase or sale of another firm’s stock or bonds.

§ Make loans or receiving loan principal repayments.Note that these transactions would be operating flows for firms in the business of makingthese kinds of deals. For example, cash expended for the purchase of a building would be anoperating flow for a firm in the business of buying and selling properties.

A reasonable shorthand way to think of Investing Cash Flows is as flows related to the purchaseor sale of long term assets. This isn't perfect, as for example some operating assets may beexpected to live for more than a year, but its usually correct.

2. Cash Flows from Financing (Financing Cash Flows, or FCFs)

Financing Cash Flows are any non-operating cash moving to or from a firm’s stakeholders.Stakeholders include a firm's owners (shareholders) and lenders (banks, bondholders, etc).Example financing transactions include:

§ Taking out a loan and repaying its principal.

§ Issuing bonds and repaying the principal.

§ Issuing or repurchasing stock (+PIC and -PIC transactions, respectively).

§ Distributing dividends to shareholders.

Financing flows are generally cash movements that are related to firm’s financial strategy or its“capitalization” (defined to be a firm's total debt and equity). Financing flows help answerquestions like “how did the firm pay for its long-term assets?”, “how were the entity's assetsfinanced?”, and “how were the firm's assets capitalized?”.


METHODS FOR CREATINGCASH FLOW STATEMENTS

There are two ways to create a cash flow statement – the “Direct Method,” and the “IndirectMethod.” Direct Method Cash Flow Statements are developed by:

d) Organizing all cash journal entries (or transaction table entries) into Operating, Investingand Financing groups.

e) Showing BOP and EOP cash balances at the top and bottom of the report. (The BOPbalance may be found on the prior period's Cash Flow Statement or Balance Sheet).

f) Checking that the EOP cash balance computed from the statement being created matches thecorresponding balance sheet number). IE: Checking that CashBOP + ΔCash = CashEOP.

Direct and Indirect Method statements both take the approach described in a) above to createtheir Investing and Financing sections. For the Operating Section, the Indirect Method eschewsthe simple, tally-the-journal-entries approach of the Direct Method. Instead, the Indirect Methodstarts with Net Income for the period. It then lists the changes to Net Income required toreplicate the Operating Cash Flow total produced by a Direct Method statement.

Both types of cash flow statements are important and useful. Many small companies rely ondirect method statements, while virtually all publicly traded entities report formally by the directmethod, while still using the direct method for some internal reporting. (In fact, there are onlytwo public companies I can think of that have recently used the direct method for publicreporting – EMC and Kellogg). We will study the Indirect Method carefully in a later chapter,while focusing here on the Direct Method.

DIRECT METHOD CASH FLOW STATEMENT EXAMPLE: WEA Q1Let's assemble a direct method Cash Flow Statement for WEA's Q1, using the firm's Q1 journalentries and the fact that its BOPQ1 cash balance was zero. Once again, the firm's buyout ofPartner 2 is included in the quarter to increase the quarter's excitement.


Our first step is to flag all entries that include a change in cash as shown:


Our second step is to sort the cash entries into operating, investing and financing groups, whilerecording the purpose of each cash change:


Our third and final step is to subtotal by account, and put the resulting numbers – along withBOP and EOP balances – in Cash Flow Statement format:

Here are some good things to note about the completed statement that apply to all CFSs:

1. As with all financial statements, CFSs must be titled, indicate the name of the entityconcerned, the accounting period covered, and units (if not US dollars).

2. BOP and EOP cash levels are indicated, and must match their corresponding balance sheetentries.

3. The report carries an algebraic sign convention, with inflows carrying positive signs andoutflows holding negative signs. (Recall the Income Statement is the only financial reportwith a non-algebraic sign convention).

4. Like all reports except the Statement of Owners Equity, CFSs show account subtotalsinstead of transactional detail.

What WEA's CFS Does and Does Not Say:A quick review of WEA's Q1 CFS reveals some notable points and suggests the need to analyzeCFSs in concert with other financial reports:

1. No net cash came in from operations. Is this a bad thing?

The answer here is 'not necessarily.' Usually businesses expend cash upfront to help themprovide a service or deliver a product, and get paid at a later time. The Revenue line of the


IS would help us here, by showing how much cash was earned, irrespective of whether ornot the associated cash had been received at the end of Q1.

2. The Loan financing flow and the single PIC entry reported on the CFS to not begin to tell usthe financial story of the partner 2 buyout. A casual reader could miss this important set offinancial events if he did not review WEA's Statement of Owners' Equity and Balance Sheetalong with the firm's CFS.


GAAP VS IFRSAs noted in Chapter 3, the US' financial accounting framework is called Generally AcceptedAccounting Principals, or GAAP. Legally, the Securities and Exchange Commission (SEC) ischarged with defining GAAP. The SEC has outsourced this task to the private, not-for-profit“Financial Accounting Standards Board,” or FASB. The rules and principles of accountingthroughout most of the rest of the world are called “International Financial Reporting Standards”(IFRS), and are established by the “International Accounting Standards Board” (IASB).

The GAAP approach to defining financial accounting is to set out a very detailed set of rules fora huge number of circumstances. IFRS, by contrast, is a more principles-based system, whichaims to lay out general principles that can be adopted to a number of specific situations.

As of 2013, more than 120 countries require the use of IFRS while the US is virtually alone inemploying US GAAP. This increases the accounting burden on any IFRS-reporting entity thatmust produce financial statements for US regulators. To overcome this and otherinconveniences, FASB and the IASB are working to merge GAAP and IFRS. I'm not holdingmy breath – for every year I've been involved with accounting and finance, the two groups havesuggested that the merger of the two systems may occur within about five years.

This situation reminds me of the twenty years in the 20th century that the US was supposed totransition to the metric measurement system within 5 to 10 years. Now in the 21st century,America's impending move to metric is no longer discussed in polite company.


ENTITY TYPOLOGY, INVENTORY AND

COST OF GOODS SOLD (COGS)

CHAPTER 7


ENTITY TYPOLOGY

For accounting purposes, entities may be classified by the products and/or services they provide.For example, Tesla Motors (stock symbol TSLA) primarily sells tangible goods – luxuryelectric-powered cars – and may accordingly be called called an “industrial” company. Bycontrast, WEA and HCP provide services – asset management and the right to inhabit a spacerespectively – making them “service” or “consulting” entities.

We will classify entities in three broad groups – Industrial, Service or Consulting and Financial– as shown in the below table. (Much finer classifications are obviously possible, but not neededfor our purposes). Companies with significant operations in two or more categories will becalled Combination entities.

Each entity type will experience some unique economic events, and their associated recordingand reporting will reflect this. Also, the recording and reporting of some common events may betreated differently by each type of entity. For example, receiving loan interest is considered aprimary source of revenue for a Financial firm, but is called “other revenue” when received byindustrial and consulting entities.

Revenue earnedprimarily from: Entity type: Examples:

1. Selling tangible goods. Industrial Tesla, Lenovo, Lemonade stand.

2. Fee for a service. Service Architects, WEA, HCP.(Consulting)

3. Investment interest, Financial Banks, payday lenders. dividends or capital gains.

4. Selling goods and Combination Apple services.

CHAPTER7–ENTITYTYPOLOGY,INVENTORYANDCOSTOFGOODSSOLD PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

INDUSTRIAL ENTITY ACCOUNTING

Until now, we have primarily studied the accounting practices of Consulting or Service entities.Now lets explore the economic and accounting peculiarities of Industrial firms.

Consider the FastBikes motorcycle dealership in Marin County, CA. The firm's key, day-to-dayeconomic events are: Buying motorcycles from (say) Suzuki, Aprilia and Zero Motorcycles. Selling these items to consumers.

These events are treated by GAAP Accounting as follows:A) When FastBikes purchases a motorcycle. The purchased motorcycle is an asset, called “Inventory.” The cost of the bike is recorded in the firm's Cash or Accounts Payable account. No expense is incurred.This treatment is similar to the recording of PPE purchases that we have seen for Servicecompanies.

B) When the firm sells a motorcycle: Revenue is recorded, at the sale price of the bike. Cash or Accounts Receivable is increased by the same amount. The Inventory asset account is reduced by the cost of the motorcycle (in recognition that the

firm no longer owns this asset). The firm records a “Cost of Goods Sold” Expense (“COGS” Expense), equal to the amount

of the Inventory reduction (IE: equal to the cost of the bike).The first two items follow the recording of revenue for service firms. The last two items areunique to the day-to-day sale of tangible goods.

INVENTORY IN-DEPTHAccrual accounting formally defines Inventory as these two types of things:

1. Tangible items that are held for sale in the ordinary course of business, or items that are inthe process of production for normal-business sales.

2. Labor and other costs that are directly required to fabricate or assemble completed, ready-for-sale products.

Other important characteristics of Inventory are that:

a) It is a current asset. (IE: it only includes things that will be sold within one year).


b) It does not include (by definition) the cost of a firm's sales force. This rule is a bit counter-intuitive, but as it is definitional we will be sure to follow it. The cost of a firm's sales forceis usually consolidated into “Selling, General and Administrative” expense (“SGA”expense) for Income Statement reporting. We will look at SGA closely in a future chapter.

EXAMPLE:Is a tractor an inventory item for:a) Caterpillar Corporation?b) A farm?If not, what asset category should the item be placed in?

Solutiona) Yes. The firm's day-to-day business is the manufacture and sale of tractors and other heavyequipment.b) No. Farms are primarily in the business of growing and selling crops and livestock, nottractors. A tractor is PPE for a farm, as it will be used to help generate sales over a long period.

ANOTHER EXAMPLE:

Consider Centex Corporation (CTX), which isin the business of producing and selling single-family homes. (Firms like this are called“homebuilders” on Wall Street).

Which of the following is inventory for CTX?c) Land that CTX plans to develop in 5 years.d) Homes – completed and in construction.e) Labor costs that are directly associated with home construction.f) The electric bill for house under construction.

Solutiona) No. This is not a current asset. (Note that the answer to this question depends on CTX's

intent).b) Yes.


c) Yes.d) Yes. (You could argue for “No” if you believe that all homes should be constructed Amish-

style, with no power tools or electric lighting).

RELATIONSHIPS BETWEEN INVENTORY, COGS,AND REVENUERecall that when an industrial firm purchases inventory, it incurs no expense even thoughinventory is an integral part of its day-to-day business. As discussed above, firms know that thecost of their inventory must ultimately be expensed, but they postpone recording this cost as anexpense until the inventory is sold and revenue is recorded.

So for industrial entities, there are always two important recording tasks to complete when apiece of inventory is sold:

3. Recording the revenue, seen in journal entry form as:

dr $xxx Cash or AR (typically) (A)cr $xxx Revenue (E)

4. Removing the sold item from Inventory and recording the expense associated with the item.Typical journal entries for this “matching” of expense to Inventory sold are:

dr $yyy COGS Expense (L) ; recognize the expensecr $yyy Inventory (A) ; remove the asset

Over any given accounting period, Inventory and COGS are related by this “roll forward”equation:

InventoryEOP = InventoryBOP + Purchases – COGS – Write Downs

With a little thought, this equation should make sense. It is useful for many real-worldaccounting problems and is definitely worth memorizing.

INVENTORY, COGS, AND REVENUE EXAMPLE

Consider the Green Car Company, LLC (GCC) of Braddock, PA. GCC buys used diesel VWs,converts their engines to run on 100% bio-diesel, then resells them to individuals andcorporations.


2011 Jetta TDI (Diesel)

GCC's conversion challenges are centeredaround the viscous properties of bio-fuels. Mostbio-diesel has about the same energy density asits petro-chemical based cousin, but it is moreviscous, especially at low temperatures asshown in the adjacent graph. (Viscositymeasures resistance to flow. Honey andmolasses, for example, are relatively viscousfluids, while water has a relatively lowviscosity).

GCC modifies the fuel systems of its cars byincreasing the diameter of fuel injectors, andinstalling heating elements along fuel lines.

Let's create GCC's journal entries and associated financial statements for an unusually simplepurchase-modify-sell cycle for one car:

1. GCC buys a car to refurbish for $15K, and gets invoiced.2. GCC sells the car to a Jetta fanatic for $20K before it has time to do any reconditioning, and

invoices this customer.

Using the dr/cr convention for journal entries, these two events are recorded as follows:

1. dr Inventory $15,000. (A)cr AP $15,000. (L)


2. dr AR $20,000. (A) Recognize the revenue.cr Revenue $20,000. (E)dr COGS $15,000. (E) Match the expense.cr Inventory $15,000. (A)

We may now build GCC's financial statements for this buy-sell cycle, by treating it as a singleaccounting period.

Income Statement (IS) for the period:

Revenue $20KCOGS Expense $15KNet Income $5K

ΔBalance Sheet (ΔBS) at EOP:(We use the term “ΔBS” because here we will not include beginning of period balances.Therefore, we will see only changes to GCC's Balance Sheet incurred during the buy-sellaccounting period).

Assets:Accounts Rec. $20K

Liabilities:Accounts Payable $15K

Owners’ Equity:NI $5KLiabilities + Equity: $20K

These “Several-Event Financial Statements” (SEFSs) help reinforce our understanding of GCC'seconomics. The Income Statement Shows GCC earns income by selling cars for more than itpays for them. The ΔBS shows the typical assets and liabilities we can expect to see on GCC'sformal Balance Sheets arising from its primary, day-to-day operations. It also shows, via the“NI” term, how the firm builds equity through its primary business.

SEFSs are often helpful in understanding a particular set of economic events experienced by anentity, and we will therefore continue to use them. (Recall that we have already used ΔBSs tohelp us understand the implications of the federal government's Q4-2008 investment in FNM).

ACCOUNTING CONCEPTS, CONTINUEDRecall our accrual accounting concepts:1. Accrual,


2. Duality,…8. Conservatism,9. Realization,10. Matching,…

Lets review and refine the Conservatism and Realization concepts to accommodate accountingpractices for industrial companies.

Recall that the Conservatism Concept establishes rules for how to value assets and recognizerevenues and expenses. Specifically it says these three things:1. As appropriate, reduce value of assets from cost (or cost minus wear) to market value.2. Recognize only revenues and additions to equity that are reasonably certain.3. Recognize all expenses and liabilities that are reasonably possible.

The implications of this concept for inventory are:a) The value of inventory must be written down in some circumstances.b) Inventory-related expenses are recognized as soon as inventory is sold or written down.

Recall that the Realization Concept establishes when to record revenue, in saying:Recognize revenue when products or services are delivered (and not before). Following thisconcept, revenue recognition for CTX, GCC and WEA works as follows:

For Entity Type Recognize Revenue When

CTX Industrial House title is transferred.

GCC Industrial Car is delivered.

WEA Consulting When invoice delivered.

Now lets add the Matching Concept to our repertoire. The Matching Concept is similar to theRealization Concept, except it establishes when to record expenses, instead of revenues. It saysspecifically:a) Inventory costs associated with the revenues of a given period are “expensed” (recorded as

expenses) when that revenue is declared. The associated recording methodology is: First determine the revenues. Then expense the matching inventory costs.

b) The cost of long-lived assets like PPE, patents or mineral deposits should be expensed overtheir useful lives. IE: the costs are matched to the periods in which they provide aneconomic benefit. For example, a new truck with a 10 yr life and no salvage value willgenerate a depreciation expense equal to 1/10th of its cost, for the next 10 years.

Reminder:


As we have seen before, matching expenses for PPE, patents and mineral deposits are called,respectively, depreciation, amortization and depletion.

c) Other normal, day-to-day business costs (or declines in value of assets) are expensed as soonas they are reasonably possible. IE: HQ staff salary; inventory write down, etc.

ANOTHER INVENTORY, COGS AND REVENUE EXAMPLELet's create GCC's journal entries and associated financial statements for the typical purchase-modify-sell cycle of a GCC bio-diesel conversion. The economic events usually experienced byGCC for the purchase, modification and sale of a single car are something like these:

At BODay-1, GCC:1. Buys a car to refurbish for $15,000, and gets invoiced.2. Buys a $1,000 fuel injection kit for the car, paying with cash.

At EODay-2, GCC:3. Notes its single employee has been working for two days on the car at $400/day4. Notes that rent and electric charges to the shop during the two-day period were $100.5. Sells the refurbished, 100% bio-diesel car for $25,000, and invoices the purchaser.

The Journal Entries for these events are:1. dr Inventory (A) $15,000

cr AP (L) $15,0002. dr Inventory (A) $1,000

cr Cash (A) $1,0003. dr Inventory (A) $800

cr Accrued salary (inventory) (L) $8004. dr Inventory (A) $100

cr Accrued rent and electric (inventory) (L) $1005. Hint: Recognize the revenue, match the expense.

dr AR (A) $25,000cr Revenue (E) $25,000dr COGS Expense (E) $16,900dr Inventory (A) $16,900

Self-Testing Tip:You should be able to reproduce these journal entries yourself.

Note that GCC's employee has spent all her time refurbishing the car, and is therefore addingvalue to inventory. Similarly, the shop itself and the electric power provided to it are necessaryto create GCC's finished product, so these also add to inventory.


Also, the associated accrued liabilities are flagged as “inventory” for the purpose of internalreporting. (GCC's CFO may well want to see, for example, how much of the firm's rent andelectric expense is for its shop, and how much goes to its executive offices). These items wouldprobably be aggregated with other accruals into a single “Accrued Liabilities” account forreporting on GCC's quarterly or annual Balance Sheets.

Now lets create Several Event Income Statements and ΔBalance Sheets for this one-car time-frame. Lets consider the times covering:a) BOD-1 thru Journal entry 4, andb) BOD-1 thru Journal entry 5.

Sorting all of GCC's journal entries for events 1 through 5 by account and Asset/Liability/Equitytype, and highlighting event 5 entries (representing the sale of the car) in red yields:

Asset Account Entries

cr Cash $1,000

dr Accts. Rec. $25,000

dr Inventory $15,000

dr Inventory $1,000

dr Inventory $800

dr Inventory $100

cr Inventory $16,900

Liability Account Entries

cr AP $15,000

cr Accrued rent/elec. $100

cr Accrued salary $800

Owners Equity (IS) Entries

cr Revenue $25,000

dr COGS Expense $16,900

Working from this sorted list, we (easily) produce GCC's ΔBalance Sheet and Income Statementfor the period BODay-1 through Journal Entry 4:

ΔBalance Sheet

Assets

Cash ($1.0K)

Inventory $16.9K

Total Assets $15.9K

Liabilities

Accounts Payable $15.0K

Accrued Expenses $0.9K

Total $15.9K

Owners Equity $0.0K

Liabilities + Equity $15.9K

Income Statement


Revenue $0.0KExpense $0.0KNet Income $0.0K

As in the prior example, the above ΔBalance Sheet shows us the types of GCC's Assets andLiabilities associated with its primary business operations. The Income Statement reinforces thefact that that GCC normally incurs no inventory-related expense for unsold items.

Here are GCC's ΔBalance Sheet and Income Statement for the Period BODay-1 through JournalEntry 5, produced again from the above list of sorted entries:

ΔBalance Sheet

Assets

Cash ($1.0K)

Accounts Receivable $25.0K

Inventory $0.0K

Total Assets $24.0K

Liabilities

Accounts Payable $15.0K

Accrued Expenses $0.9K

Total $15.9K

Owners Equity $8.1K

Liabilities + Equity $24.0K

Income Statement

Revenue $25.0KCOGS Expense $16.9KNet Income $8.1K

This ΔBalance Sheet reflects GCC's situation after a sale. After the sale of a car, the inventoryassociated with it is gone, and equity has increased by the sale price minus the cost of theinventory. The Income Statement details money made per car as sale price (Revenue) minusinventory cost (COGS Expense).

Self-Testing Tip:Recreating the above Several Event Financial Statements is a great way to ensure that youunderstand the operating mechanics of a simple, industrial entity. Reproducing these statementsis recommended for this reason, and because it will help prepare you to create more complicated,real-world financial statements.


INVENTORY WRITE-DOWNSConsider this Inventory Write-Down (or Write-Off) example for GCC:Someone has left some of GCC's electric bio-fuel heaters out in the rain. The heaters, which cost$2,000, are now useless as inventory, but can be sold to a salvager for about $500. Find thejournal entries for this event:

Solution:cr Inventory (A) $2,000dr Miscellaneous Asset (A) $500dr Inventory write off expense (E) $1,500

As the entries imply: Since the heaters are useless as inventory, their full cost most be removed from this account. GCC gets a new asset out of this mess: $500 worth of stuff to sell to a scrapper. Since this

sort of asset should not appear often, its fair to label this it as a “Miscellaneous Asset.” The net amount of the inventory write down is a reduction to the firm's equity. The equity is

reduced by declaring this amount as “Inventory Write Off Expense.” It is virtually alwaysthe case that the net amount of a write-down (of Inventory, PPE or any other asset) reducesequity through a Write Down Expense.

Some general implications of an inventory write off are: Inventory must always be “written down” to its current value whenever the value falls below

cost.Inventory is accordingly said to be “carried at lower of cost or market value”.

The equity-reducing expense associated with an inventory write off may be recognized aseither “Inventory Write Off” expense or “COGS” expense. Accounting experts suggest(properly) that large write offs should be recognized as the former. Their reasoning is thatusing “Inventory Write Off” provides readers of firms' Income-Statements with more andbetter information. If “COGS” is used, an outside-the-firm reader would not know that awrite-down occurred.

A write down is recorded as soon as the inventory's value (or the value of any other asset forthat matter) falls, irrespective of any revenue recognition. If the write down is handled witha COGS Expense, this is an exception to COGS matching revenue.

Here is a simple Inventory Write Down example, where it is appropriate to reduce equity usingCOGS Expense:

Consider a banana importer who owns a load of bananas costing $2,000K. The bananas are inthe hold of a ship in NY Harbor, and they have not been unloaded due to a conflict with the localteamsters union.


As Marlon Brando pointed out in the classicfilm On the Waterfront, “Them bananas go badin a hurry.”

Due to their ripening, the importer estimates the bananas' worth at $1,600K. He will still sell theentire batch as “bananas,” but will receive a reduced price as his grocery customers prefer topurchase less-ripe fruit.

Here are write-down journal entries for the unfortunate importer:cr Inventory (A) $400Kdr COGS (E) $400K

A NOTE ON THE REAL-WORLD TREATMENT OF

COGSSome companies find it easiest to recognize only revenue as sales are made during an accountingperiod, and match the associated COGS Expenses when preparing financial statements at the endof the period. This example shows how GCC's inventory-related event-recording would work ifit followed this practice:

Events:1. At BOP, GCC buys a car to refurbish for $15K, and gets invoiced.2a. The next Day, GCC sells the unaltered car for $20K, and invoices the customer.2b. At EOP, GCC prepares financial statements for the period.

Journal Entries1. dr Inventory (A) $15,000.

cr AP (L) $15,000.2a. Recognize the revenue and payment owed at the time of the sale:

dr AR (A) $20,000. cr Revenue (E) $20,000.2b. Reduce inventory and match the expense when compiling the firm's next set of financial

statements:dr COGS Expense (L) $15,000.

cr Inventory (A) $15,000.


MORE COMPLICATED INVENTORY SCENARIOSThroughout most of this text, each inventory item we've discussed has been easy to identity andto transfer to COGS Expense. Green Car Company's inventory, for example, is comprised ofindividual cars as well as components and labor used for specific vehicles. This type ofinventory is tracked with the Specific Identification Method.

Tracking inventory and COGS for other types of entities is more complicated. A fuel oildistributor, for example, may fill its thousand-gallon storage tank with three batches of oil asfollows:

Purchase date Gallons Price/Gallon1/1/20X1 500 $4.002/1/20X1 300 $3.003/1/20X1 200 $2.00So the average cost to fill the tank is $3.30 per gallon

The firm may then sell 200 gallons on 3/31/20X1 for $1,000 or $5.00 per gallon. In this case,the firm has three choices for establishing the associated COGS Expense for the period 1/1through 3/31:

1. Using the Average Cost Method, the firm would record COGS Expense as $3.30/gallon *200 gallons = $660.

2. Using the First-In, First-Out Method (the FIFO Method) the firm would record COGSExpense as $4.00/gallon * 200 gallons = $800. Here the firm uses the price of its firstinventory purchase to compute COGS, and would continue to use this price ($4.00 pergallon) until it has sold 500 gallons.

3. If the firm chooses the Last-In, First-Out Method (the LIFO Method), it would record COGSExpense as $2.00/gallon * 200 gallons = $400. Here the firm would be using the price of itsmost recent inventory purchase to compute COGS. COGS Expense for its next sale wouldbe at $3.00 per gallon (or some combination of $3.00 and $4.00 per gallon for a large sale),because the all the fuel it purchased for $2.00 per gallon would be gone.

As of the writing of this book (2013), LIFO inventory costing is allowed by GAAP but not byIFRS standards. The IFRS bans LIFO for two reasons: First, LIFO makes the inventory shownon an entity's balance sheet less reflective of current market conditions that FIFO; second, in aninflationary environment where prices are rising (which is the norm for most economies), LIFOwill maximize COGS Expense and thereby minimize taxable income.


SGA, DEPRECIATION REVISITED,AND TAXES

CHAPTER 8


SELLING, GENERAL,AND ADMINISTRATIVE EXPENSE (SGA)

Selling, General and Administrative Expenses (SGA) are defined to be expenses associatedwith the routine production of goods and services that are not: COGS, Interest, Depreciation, Write-Downs, Other Income (Expense) or Tax. Additional separately-reported expenses.

In practice, SGA is primarily used in Income Statements as an aggregating account that includessome expenses that have been recorded individually. For example, SGA may include accruedadvertising, salary and rent expenses. As a general rule its good to record events using a highly-specific set of accounts, and defer aggregating into SGA until Income Statements are produced.

Exactly what gets aggregated into SGA and what becomes a “separately-reported expense” is afunction of an entity's reporting condensation policy and its industry. Technology firms likeTwitter and Microsoft, for example, usually do not include Research and Development expensesin SGA, because their R&D costs are big and their Income Statement readers want to know howmuch they spend on creating new products. On the other hand, a company like HCP spends avery small amount on R&D, and is therefore likely to include this expense in SGA.

As with virtually all expenses except for the inventory-related COGS account, SGA expenses arenot “matched” to revenue. IE: They are incurred as as soon as reasonably probable, per theMatching and Conservatism concepts.

SGA EXAMPLE FOR GCC:GCC has just relaxed its accounting policies for reporting financial statements. Going forward,the firm will record and report all of its operating expenses as SGA except for depreciation,COGS, interest, write-downs and taxes.

Consider a one-day reporting period for GCC. At the end of a day, GCC notes that:1. Its accounting staff earned $1,000 of salary.2. It purchased sales fliers costing $500 on credit.3. Its single shop employee worked all day on a car, earning $400.

Find the journal entries for the day's events, and an Income Statement for the period (assumingnothing else happened in the period and remembering that GCC is an LLC).

Solution:Journal Entries:1. dr Salary Expense $1,000 (E)

cr Accrued Salary $1,000 (L)

CHAPTER8–SGA,DEPRECIATIONREVISITEDANDTAXES PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

2. dr Marketing (Sales) Expense $500 (E)cr Accounts Payable $500 (L)

3. dr Inventory $400 (A)cr Accrued Salary (Inventory) $400 (L)

Income Statement:

Revenue $0SGA Expense $1,500Net Income ($1,500)

Note that GCC continues to specifically identify Salary and Marketing expenses when recordingevents, and only aggregates these items when creating an Income Statement. This enables thecompany to prepare finely-grained reports for internal purposes and for audits.

Also note the difference in GCC's handling of its accounting staff's salary versus its shopemployee's wages. As usual, the shop employees wages will not be expensed until the car sheworked on is sold. At this time her contribution to Inventory will be converted to COGSexpense.


DEPRECIATION REVISITED

Recall that depreciation is thought of as: The process of expensing the cost of a long-lived asset – such as PPE – over the asset’s

“useful life”, and The the process of reducing the book value of a long-lived asset as its “useful life”

decreases. Here “useful life” is established by FASB or a firm's accounting policies, andmay not be the same thing as the actual life of the asset.

Let's review how we have treated depreciationuntil now, through looking at the life of a CNCmill used by GCC to modify cars' fuel injectors.

The important accounting aspects of this millare:GCC purchased it on 12/31/20X0.

It cost $50,000. (This is the mill's “initialbook value”).

GCC expects the mill to have a 5 yr usefullife and no “salvage value.” (IE: the millwill have no resale value at the end of itsuseful life).

GCC uses “straight line” (linear)depreciation. This means that the companyexpenses a constant % of its assets' cost peryear. For this mill, GCC will expense onefifth (20%) of its cost per year.

We’ve previously learned to account for mill asset and its aging as shown in these journalentries:

12/31/20X0: Buy the mill, paying with cash

dr Net Mill Asset (PPE) $50,000 (A)cr Cash $50,000 (A)

12/31/08: Reduce book value of mill by 20%, and incur an expense for 20% of the mill'svalue:

dr Depreciation Expense $10,000 (L)cr Net Mill Asset $10,000 (A)


Although this method is often used in finance1 and yields correct financial statements, it is notexactly what GAAP requires. The GAAP method of handling the mill and its depreciationare slightly more complicated.

We've put off discussion GAAP-sanctioned depreciation until now because, as Jack Nicholsonmight have said in “A Few Good Men”:

'You couldn't havehandled the truth!'

Specifically, I felt that so many concepts and so much new vocabulary was being thrown at youthat it was best to postpone the complex, sometimes unnecessary topic of GAAP-sanctioneddepreciation until you had mastered the basics. See if you agree after learning about the fullblown GAAP treatment.

GAAP says to report depreciating assets on Balance Sheets as follows:

Asset cost- “Accumulated Depreciation” (representing the total depreciation of the asset since purchase)= today’s “Book Value” (or today's “net Asset Value”)

To enable this reporting, we record economic events for depreciable assets like this:

1. When a depreciable item is purchased, establish:

a) An asset account for the cost of the item. This account value will stay constant for thelife of the asset. So when GCC buys a mill we will establish a “Mill Asset” account,instead of a varying-value “net Mill Asset” account.

b) An “Accumulated Depreciation” account (AD), to show the wear or reduction in valueof the asset. AD accounts are called “contra asset” accounts, and work like this:

They are associated with a specific asset or group of assets (such as a specific millAsset or all of a firm's PPE).

1 This method is commonly used for projecting financial statements into the future. This projection process iscalled “creating pro-forma projections”.


In dr/cr parlance, an addition to a contra asset account is designated with “cr.”

When shown on a balance sheet, these accounts appear directly below the assetthey are associated with. In this sense they are like a pilot fish is to a shark.

Using this Accumulated Depreciation methodology, let's record annual EOY journal entries forthe life of GCC's mill, and prepare partial financial statements for key years.

12/31/20X0 events and journal entries:

GCC buys the mill, paying with cash.

dr Mill Asset (PPE) $50,000 (A)cr Cash $50,000 (A)

At this time we also set up the “Accumulated Depreciation of Mill” contra-asset account, but donot make any entries to it.

12/31/20X1 events and journals:

At the end of the next year, we need to reduce book value of the mill by 20% and incur anexpense for 20% of mill’s value. (IE: we need to report one year’s worth of wear). Theappropriate journal entries are:

dr Depreciation Expense $10,000 (L)cr Accumulated Depreciation $10,000 (A)

We make no entry to the Mill Asset account at this time, and going forward we will continue tomeasure wear of the mill through the Accumulated Depreciation account.

12/31/20X1 Financial Statements (partial statements):

Balance Sheet:Mill Asset $50,000less Accumulated Depreciation -$10,000Book value of mill (net Mill Asset) $40,000

Income Statement:

Revenue $xxxExpensesCOGS $xxxDepreciation $10,000


Reduce book value of mill by 20%, incur expense for 20% of mill’s value.

dr Depreciation Expense $10,000cr Accumulated Depreciation $10,000

Again we make to entry to the “Mill Asset” account.


Good to Know:Depreciation occurs at all times, and is not just measured annually or quarterly. IE: if we werepreparing GCC financial statements for the month ending 1/31/20X2, our Depreciation Expenseand Accumulated Depreciation entries would be $833 = $10,000 / 12.

12/31/20X2 Financial Statements (partial):

Balance Sheet:Mill Asset $50,000less Accumulated Depreciation -$20,000Book value of mill (net Mill Asset) $30,000

Income Statement:


Note that the Depreciation Expense is still reported as $10,000, representing one year's worth ofwear, while Accumulation Depreciation is now $20,000, representing the total wear of the millsince its purchase.

12/31/20X5 (end of mill's life) events and journal entries.

(Note that we have skipped years 20X3 and 20X4, although GCC would of course continue torecord Depreciation Expense and Accumulation Depreciation during these times):

First, as usual, we need to reduce the book value of the mill by 20%, and incur an expense for20% of mill’s cost:

dr Depreciation Expense $10,000 (L)cr Accum. Depreciation $10,000 (A)

Next we zero-out the balance of the Mill Asset account and its pilot-fish AccumulatedDepreciation account, as the mill has completed its useful life:

dr Accum. Depreciation $50,000 (A)cr Mill Asset $50,000 (A)


Balance Sheet:

The Mill Asset and its contra-asset Accumulated Depreciation account are not shown as boththeir balances are zero.


Income Statement:


Here are couple more good things to remember about depreciation:

1. Although we've usually thought of depreciation as a measure of wear over an asset's usefullife, its also good to think of if as a way to “match” the expenditure for the asset over its usefullife, per the Matching Concept.

2. For larger companies with many depreciable assets, reporting of them on financial statementsis aggregated. All depreciable plant and equipment, for example, is reported in a single “PPE”account. Similarly, Accumulated Depreciation includes the total for all depreciable assets andDepreciation Expense represents the total reduction in book value for all of these assets.

Now that we understand the mechanics of GAAP-style depreciation reporting, let's considersome questions that shed light on the meaning, consequences and importance of depreciatingassets:

1. Should GCC throw away mill at EOY 20X5?

2. If GCC keeps using mill after 20X5, how will this impact its profitability?

3. Do depreciation expenses ever result in cash flows?

4. Does depreciation expense matter?

Answers:1. Of course not! The mill's “useful life” of five years was just an accounting estimate. If the

actual mill is working properly at the end of its useful life and GCC still finds it helpful, thefirm should of course keep working with the machine.

2. All else equal, GCC's profits will go up after 20X5 because it will no longer incur adepreciation expense for the mill. If the firm buys a new mill in 20X6, then of course theywill take a depreciation charge for this new machine.

3. No, depreciation does not cause a change in cash. As we've seen in the above journals, theother side of a Depreciation Expense entry is always Accumulated Depreciation.

4. If depreciation is not ever associated with cash flows, should it matter? Is it just a fictionused by the accounting profession to be obfuscational and help ensure accountants' jobsecurity? Actually, in many cases depreciation does matter. This is especially true for largecompanies in “steady state” mode (not growing to fast or redefining their business missions)with many depreciable assets. For these firms, depreciation gives financial-statementreaders a decent estimate of how much an entity should spend to maintain its PPE. This canbe compared to an entity's reported Capital Expenditures (shown in the Investing section ofthe Cash Flow statement), to see if the firm is under-investing in its PPE. Sustained under-


investing could wreak financial and operational havoc when things start breaking down inthe future.

DEPRECIATION WITH SALVAGE VALUECompanies often recognize that when a depreciable asset's useful life is over, it may still bevaluable to another firm, and its sale may bring in some cash. For example, GCC may believethat its 5 year old mills are worth $10-$12,000 to refurbishing firms, which are in the business orrestoring and reselling industrial equipment. In these cases, firm's estimate this “salvage value”of their PPE at purchase, and adjust their depreciation schedules accordingly.

Let's see how GCC's accounting treatment of its mill would look if it assigned it some salvagevalue. Let's say: GCC’s policy is to replace its mills every five years. (This policy stems from GCC's views

on technological obsolescence and the reduced reliability of its older mills). GCC estimates that the mill it buys on 12/31/20X0 for $50,000 could be sold to a refurbisher

for about $12,500 at EOY 20X5. IE: GCC assigns the mill a salvage value of $12,500.

Now GCC wants the book value of the mill to be $12,500 at the end of its useful life, instead ofzero. Accordingly, it will depreciate the mill by $7,500 per year. GCC get this amount byapplying this equation:

Book Value = (Cost – Salvage Value) / (Years of Useful Life)

IE: 7,500 = (50,000 – 12,500) / 5.

We may check that this is appropriate as follows:a) $7,500 per year * 5 years = $37,500 total depreciation of the mill over its useful life.b) $50,000 cost – $37,500 total depreciation = $12,500 book value = desired salvage value.IE: after 5 years of depreciation at $7,500 per year, the book value of the mill will be $12,500, asdesired.

Now we can create annual journal entries and partial financial statements for the life of the mill.12/31/20X0 events and journals:

GCC buys the mill, paying with cash.

dr Mill Asset (PPE) $50,000 (A)cr Cash $50,000 (A)

At this time we also compute the annual depreciation amount, as shown above.($50,000 – $12,500)/(5 years) = $7,500/yr


Reduce the book value of the mill by $7,500, and incur depreciation expense for $7,500.




Balance Sheet ($K, UON)

Mill Asset $50.0Less Accumulated Depreciation ($7.5)Book value of mill $42.5

Income Statement ($K, UON)

Revenue $xxxExpensesCOGS $xxxDepreciation $7.5

12/31/20X2 Journal entries:

dr Depreciation Expense $7,500cr Accumulated Depreciation $7,500



Mill Asset $50.0Less Accumulated Depreciation ($15.0)Book value of mill $35.0


Revenue $xxxExpensesCOGS $xxxDepreciation $7.5

13/31/20X5 events and journals:

First, reduce book value of mill by $7,500, and incur depreciation expense of $7,500


Then zero out the Mill Account and its Accumulated Depreciation contra-asset account:

dr Accumulated Depreciation $37,500 (A)cr Mill Asset $50,000 (A)

Note that total debits and credits do not match here. This is because we are missing the $12,500salvage value asset that springs forth from the ashes of the mill asset at the end of its useful life.Calling the salvage asset “Equipment Held for Sale,” the complete journal entries are:

dr Accumulated Depreciation $37,500 (A)


dr Equipment Held for Sale $12,500 (A)cr Mill Asset $50,000 (A)



AssetsEquipment held for sale $12.5

The balances of the Mill Asset and Accumulated Depreciation are zero and therefore not shown.

Income Statement:


GAIN AND LOSS ON SALENow let's say that GCC sells the above mill in 20X6 for $13,000, paid in cash. The companyrecords this event as follows:

dr Cash $13,000 (A)cr Equipment Held for Sale $12,500 (A)cr “Gain on Sale of Equipment” $500 (A)

Here the Equipment Held for Sale is properly credited to zero the balance of the asset no longerowned by GCC. Additionally, “Gain on Sale” is added to ensure (among other things) that thefundamental accounting equation is satisfied and that debits equal credits for the recording of thistransaction. Gain on Sale or “Loss on Sale” entries are always used in this way whenever theamount received does not equal the book value of the asset “Held for Sale.” Gain on Sale is usedwhen the amount received is more than the asset's carrying value, and Loss on Sale is appliedwith the amount received is less than the asset's book value. Here are some important propertiesof Gain and Loss on Sale entries:

Gain (Loss) on Sale = Sale Price – Book Value.

Gain and Loss on Sale are defined respectively to be forms of Revenue and Expense. (Thesedefinitions make sense inasmuch as Gains increase equity and Losses decrease equity).

On Income Statements, Gain (Loss) entries appear near the bottom (but above the incometax line) in a section called “Other Revenue (Expense)” or “Non-Operating Revenue(Expense),” or some similar name that a wise-alec company has cooked up.

With all this in mind, here is what GCC's 20X6 Income Statement would look like after sellingthe Equipment:



Revenue $xxx

ExpensesCOGS $xxxDepreciation $xxx

Other Revenue (Expense)Gain on Sale of Equipment $0.5Loss on Sale of Something Else ($xxx)

Tax $xxxEtc.

As with many complicated aspects of accounting and finance, unscrupulous individuals canexploit the intricacies of salvage values and Gains/Losses for nefarious purposes. The followingproblem provides an example.

EXAMPLE

At EOY 20X0, GCC has: Just bought a new CNC mill. A CFO who is planning to retire after six years (At EOY 20X6). The CFO has:

A retirement bonus tied to GCC's Net Income in his last year of employment. (IE: thebigger GCC's Net Income in 20X6, the bigger the CFO's retirement bonus).

An unscrupulous demeanor.

What could the CFO do now to improve GCC’s 20X6 Net Income and maximize his retirementbonus?

SolutionAmong other things, the CFO could underestimate the salvage value of the mill. If he sets thesalvage value at zero and the firm sells the mill for $13,000 in 20X6, the firm will show Gain onSale revenue of $13,000. This would increase GCC's 20X6 Net Income by the same amount. Ifthe CFO sets the salvage value properly at $12,500, the firm will only see Gain on Sale revenueof $500 in 20X6, assuming the same sale price of $13,000.


ACCOUNTING FOR TAXESAs we have mentioned previously, Limited Liability Companies (LLCs) pay no income tax.This is also true for S-Corporations (S-Corps), and most Real Estate Investment Trusts (REITs),Master Limited Partnerships (MLPs) and Business Development Companies (BDCs). All ofthese entities do pay some taxes, in the form of filing fees, property tax, etc.

Non income-tax-paying entities provide a statement of annual profits and owners' allocation ofprofits to the Internal Revenue Service (IRS) and its owners, on an IRS “K1” form. Ownersmust declare their portion of the firm's profits on their personal income tax returns. This incomeis taxed on each owner at her individual tax rate. (Owners must also file a copy of their K1 formfor each non income-tax-paying company they own a portion of, with their individual taxreturns).

C-Corporations (C-Corps) directly pay income tax on their Taxable Income (TI). (In thesimplest case, which is the only one considered in this text, a company's Taxable Income is thesame as its Earnings before Tax {EBT}). Federal C-Corp tax rates are set by Congress and theIRS. Currently (in 2014) these rates vary from 15% to 35% of TI. Firms showing TI of $18MMor more pay at the 35% rate; firms showing less pay less.

The optimal corporate structure for a given firm depends on its industry and its long-termownership intentions. Industry is an important consideration because only firms in certainbusiness lines may take advantage of REIT, MLP and BDC tax structures. Intent for long-termownership is important as follows:

All else being equal, firms may incorporate as LLCs or S-Corps to avoid the “double taxation” ofC-Corps. Double taxation occurs when a C-Corp issues dividends. Cash available to pay adividend comes from a company's accumulated Net Income. As we know from our study ofIncome Statements, Net Income is profit remaining after tax is paid on EBT. This is the firstlevel of taxation.

When an entity chooses to pay its owners a dividend, the owners will pay 15% tax on this“dividend income” to the IRS. This is the second level of taxation.

For an LLC or an S-Corp, the first level of taxation is absent, as the entity does not pay incometax. (IE: its Earnings Before Tax is equal to its Net Income). Many firms therefore choose toincorporate as LLCs or S-Corps, so their owners may enjoy lower overall taxes on theirdividends.

Despite the tax advantages that S-Corps and LLCs enjoy over C-Corps, firms may choose toincorporate as C-Corps if they expect their a large number of stakeholders who may hold on totheir ownership stakes for a short period of time. This is exactly the ownership profile of mostpublicly-traded companies, who may have millions of owners (stockholders) at any time, and see


5% to 20% of their stock (or more) change hands in a single day2. The more owners a nonincome-tax-paying entity has during a year (including temporary holders such as short-termtraders), the more onerous its K1 reporting becomes. Also, many stock market participants mayhave never heard of a K1, or may think of K1 as a Himalayan mountain better known asMasherbrum. In either case they would be ill-equipped to file personal tax returns that includeK1 forms for every stock they traded throughout the year.

To minimize their and their owners' tax reporting hassles, the great majority of publicly-tradedcompanies organize themselves as C-Corps. Many quick-growing startup firms, aiming to enjoythe best of both the LLC and C-Corp structures, initially form as LLCs and convert to C-Corpsbefore becoming publicly-traded entities.

As noted above, C-Corps pay tax on their Taxable Income, which is not necessarily the samething as GAAP Earnings Before Tax. Taxable Income is computed on a Tax Return, which isthe same as a company's Income Statement only in simple cases. Differences between the twoare caused by the differences between the GAAP and IRS rules for revenue and expenserecognition. In this text, we will assume simple cases. More complicated scenarios are treatedin most Intermediate Accounting books and virtually all Tax Accounting texts.

EXAMPLE: TAX REPORTING FOR GREEN CAR COMPANY

Here is a simplified GCC Income Statement, developed using its LLC corporate structure:

Revenue $25.0KCOGS Expense $16.9KNet Income $8.1K

Let's now assume that GCC is: Organized as a C-Corp Pays income tax at 33% of Taxable Income (TI) Has Taxable Income that is identical to its Earnings Before Tax.

In this case we prepare GCC's Income Statement as follows:

1. Create a Pre-Tax Income Statement:

Revenue $25.0KCOGS Expense $16.9KEBT ( = TI in this case) $8.1K

2. Compute Income Tax and create tax journal entries:

dr Tax Expense 0.33* $8.1K = $2.67K (E)cr Accrued Tax $2.67K (L)

2 S-Corps are limited to 100 or fewer owners, so it is virtually impossible for this entities of this type to becomepublicly-traded.


3. Use the above journals to create GCC's finalized Income Statement as a C-Corp:

Revenue $25.0KCOGS Expense $16.9KEBT $8.1KTax Expense $2.7KNet Income $5.4K

Note that Tax Expense is the last item before Net Income. This is traditional and consideredgood practice.

Self Testing Tip:Considering the above Income Statement and how it was created, do you think a firm should aimto look financially-strong in the eyes of the IRS?

Solution:No. Financial strength is measured by the IRS as Earnings Before Tax, with bigger meaningstronger. The bigger GCC's EBT, the more tax it will pay, and the smaller its NI will become.

In general, most firms want to portray themselves to the IRS as weakly and sickly as possible,within the boundaries of the law. By contrast, NI is what redounds to entities' owners, so firmswant to make this as big as possible.

Congress has provided many, often complicated ways for firms to look less profitable to the IRSthan they do to their shareholders. One example we've already discussed is MACRSdepreciation, which is allowed by the IRS on tax returns but is disallowed within GAAP forIncome Statements. (Straight line depreciation is used within GAAP instead). The net effect isthat, for certain years, companies may report much higher depreciation expenses to the IRS thanthey report to their shareholders. This situation let congresspeople feel that they've helpedbusinesses prosper by reducing their tax burden. At the same time, it helps ensure the future ofthe accounting profession – by creating such a complicated, tedious mess that that manybusinesspeople won't attempt to sort it out by themselves3.

3 Interestingly, this situation is changing through the advent and rapid improvement of rule-based tax accountingsoftware such as TurboTax for Business and H&R Block Premium Business.


CASE STUDY:TAXATION OF INVESTMENT MANAGERS

AND ATHLETES

CHAPTER 9


TAX COMPLICATIONS

The accounting tax treatments addressed in this text apply only to very straightforwardsituations. Unfortunately, the U.S. tax codes are so complicated that straightforward situationsare rare in real life. The 2013 federal tax code, for example, weighs in at 73,954 pages. As aresult, entire graduate-level courses are devoted to taxation, in both accounting departments andlaw schools.

Some tax complications arise from a desire for fairness, such as the ostensibly “progressive”nature of the federal income tax code. Many tax idiosyncrasies are incorporated to accommodate“special interests” and their lobbyists. These peculiarities are difficult to uproot partially becausethe definition of “special interest” depends on the definer's interests. A good general definitionfor a special tax interest might be any group who wants something in the tax code that you don'tlike.

Here is an example of a special-interest-driven tax code anomaly. Look it over and see if youthink its fair and/or appropriate.

TAXATION OF ATHLETES AND INVESTMENT

MANAGERSMost professional athletes are taxed as individuals. They pay income tax on their base salariesand performance bonuses based on their individual tax returns.

Although private equity and hedge fund managers primarily earn income through the profits oftheir investment firms, they are also taxed as individuals. This is because managers' investmentfirms are usually organized as Limited Liability Corporations (LLCs), which generally pay noincome tax directly. Instead, an investment firm's profits are declared by its owners on theirpersonal tax returns, and taxed at the individual level.

Both professional athletes and investment managers may make millions of dollars per year,putting them in the highest income tax bracket. Currently (2013) the top federal tax bracket is35%, a rate that starts with incomes over $388,350 per year, as shown in this table:

Individual Federal Income Tax Rates (For 2012 tax, head of household):

10% on taxable income from $0 to $12,400, plus 15% on taxable income over $12,400 to $47,350, plus 25% on taxable income over $47,350 to $122,300, plus 28% on taxable income over $122,300 to $198,050, plus 33% on taxable income over $198,050 to $388,350, plus 35% on taxable income over $388,350.

CHAPTER9–CASESTUDY:TAXATIONOFINVESTMENTMANAGERSANDATHLETES PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

Most individuals, including professional athletes and investment managers, pay lower tax rateson their investment gains than they pay on their income. “Capital” investment gains, defined assale price minus purchase price,1 are federally taxed as follows2:

The tax rate is 15% for investments held for more than a year. For investments held for a year or less, the tax rate is the individual's income tax rate (35%

for most professional athletes, hedge fund and private equity fund managers).

Although most professional athletes, hedge fund and private equity fund managers are taxed asindividuals and share the same tax brackets, the investment managers may pay significantly lesstax. This is due to a quirk in the tax laws (or a special-interest exemption in the laws, dependingon your perspective) designed for the managers. Here is how it works:

When starting a fund, a manager will raise a large amount of cash from investors, whobecome limited partners3 in his LLC. The manager will also invest some of his own cash,but the lion's share of the funds invested is from the outsiders. The outside investorstypically agree to pay the manager an annual “asset management” fee of (say) 2% of theirinvested balance, plus an annual performance bonus fee of (say) 20% of any gains madeduring the year. A good manager will typically earn much more from their performance feethan their asset management fee.

This pay structure looks a lot like the typical, base-salary plus performance-bonus paystructure enjoyed by professional athletes. But while athletes pay income tax on both theirbase-salary and their bonus, the investment manager typically pays income tax (35%) onlyon his asset management fee. He pays tax on his usually-larger performance fee at just thelong-term capital gains rate (15%).

This lower tax rate for investment managers was enacted by Congress in 1954, when it declaredthat managers' bonuses would be called “carried interest” by the IRS and taxed at the capitalgains rate. Several congressional attempts have been made to tax managers' performance feeslike everyone else, but to date (2013) these have been thwarted by hedge fund and private equitymanagers and their lobbyists.

Further ReadingWhat is Carried Interest and How Should it be taxed?; Tax Policy Center of the Urban Instituteand the Brookings Institution.http://www.taxpolicycenter.org/briefing-book/key-elements/business/carried-interest.cfm

Special Interest (The Financial Page); The New Yorker; James Surowiecki. March 15, 2010.http://www.newyorker.com/talk/financial/2010/03/15/100315ta_talk_surowiecki

1 For example, the capital gain on a stock bought for $100K and later sold for $150K would be $50K.2 Families earning less than about $70,000 per year pay no capital gains tax.3 Limited partners do not have a say in how the LLC is run or how to manage its investment strategy.

CHAPTER9–CASESTUDY:TAXATIONOFINVESTMENTMANAGERSANDATHLETES PAGE3Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

CASH ACCOUNTING

CHAPTER 10


ACCRUAL ACCOUNTING VS CASH ACCOUNTING

ACCRUAL ACCOUNTINGThe two most foundational ideas of Accrual Accounting are arguably the Accrual Concept andthe Duality Concept. Here is a reminder of their definitions:

The Accrual Concept:Measure financial events when accrued (when experienced or accumulated), regardless of whencash transactions occur.

The Duality Concept:Assets = Liabilities + Owners’ Equity,at all times under all circumstances.

The Duality Concept also implies:Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity)Where “Δ” means “change in” or “change to,” and change is measured over time.IE: Δ(Assets) = Assets(T2) – Assets(T1), etc.

CASH ACCOUNTINGThe mechanics of Cash Accounting can be developed around two similar concepts, and a changeto our definition of Owners' Equity:

The Non-Accrual ConceptThis concept states two foundational rules in the Cash Accounting world: Measure financial events only when cash transactions happen. Do not recognize any accruals.

Because we are not measuring accruals in the Cash Accounting world, our only asset is cashitself. Similarly, there are no liabilities in this system.

Owners' EquityEquity is defined in the Cash Accounting system as follows:

Equity ≡ Cashfrom which

Δ(Equity) = Δ(Cash).

As you see in these Accrual Accounting relations:


CHAPTER10–CASHACCOUNTING PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

from whichΔ(Equity) = Δ(Assets) - Δ(Liabilities)

The Cash Accounting definition of equity is similar to the Accrual Accounting definition. TheCash Accounting definition is simplified as follows: “Liabilities” have been dropped becausethey do not exist in the Cash world, and “Assets” has been replaced with “Cash,” which is CashAccounting's only asset.

The Cash-Accounting Duality Concept:With the above definition, the Cash-Accounting version of the Duality Concept is simply:

Cash = Owners Equity, at all times, andΔ(Cash) = Δ(Owners’ Equity), over all time periods.

In this system, equity accounts simply provide descriptions to changes in cash. Equity accountsare grouped into Operating, Investing, and Financing buckets. Example accounts for each bucketare:

OperatingCash revenues collected.Cash interest paid or collected.Cash paid for expenses.

InvestingPayments for the purchase or sale of PPE.Awarding a loan, or receiving repayment of loan principal.

FinancingReceiving cash when taking out a loan or issuing bonds.Repaying loan principal or bond principal.Receiving Paid-in-Capital (PIC) from owners.Paying owners dividends.


ACCRUAL VS CASH ACCOUNTING:WEA EXAMPLE

Lets complete a simple example to help us understand how Cash Accounting works in practice,and how its financial statements compare to those created under Accrual Accounting rules.

PROBLEMCreate cash-basis journals and Financial Statements for WEA’s first quarter of operations.Compare and contrast these statements with those created under Accrual Accounting. For eachstatement, explain which is superior (cash-basis or accrual) and why.

Events experienced by the company during the quarter:

1. The company is formed.

2. WEA's owners pay in $10,000 (PIC) for 10,000 shares.

3. The company buys $5,000 of furniture, computers, using a company credit card.

4. The company invoices $8,000 in revenue. Customers paid $4,000 cash at time of invoicingand agree to pay the remaining $4,000 within 60 days.

5. WEA incurs and pays Salary Expense of $3,000 and Rent Expense of $1,000.

6. The company pays its owners a dividend of $2,000.

SolutionCash-Basis Journal Entries:

1. No entries (no change in cash).

2. DR Cash $10,000 (A)CR PIC $10,000 (E)

3. No entries (no change in cash).

4. DR Cash $4,000 (A)CR Revenue $4,000 (E)

5. DR Salary Expense $3,000 (E)DR Rent Expense $1,000 (E)CR Cash $4,000 (A)

6. DR DIV $1,000 (E)CR Cash $1,000 (A)


Balance Sheets

Cash-Basis

Accrual-Basis

Comparing these two financial reports, its clear that the accrual Balance Sheet contains all theinformation shown on the cash-basis report, plus additional information about accruals. Forexample, WEA's accrual-basis statement shows that the firm owes its creditors $5,000, which isleft unreported on the cash-basis statement. So the accrual method is unambiguously best forBalance Sheets.

Income Statements

Cash-Basis

Accrual-Basis


In this case its not so obvious which statement is best. Both Income Statements (ISs) showrevenue and all expenses for the period.

The cash-basis statement looks more conservative (and therefore maybe better) because it onlyreports only the $4,000 of revenue that has actually been received. However, this is the same'actually received' revenue that will be shown on WEA's Cash Flow Statement (see below).

The accrual-basis Income Statement includes the $4,000 of revenue declared and collected, plusthe additional $4,000 of revenue that WEA expects to collect in cash soon. The accrualstatement does not identify how much cash revenue is uncollected, but is easily obtained bysubtracting the collected revenue shown on the Cash Flow Statement from the total revenuedeclared on the Income Statement. (IE: $8K total revenue - $4K collected in cash = $4Kuncollected).

As with its Balance Sheets, WEA's Accrual Accounting Income Statement provides us withmore useful information than its cash-basis cousin, if we use it in concert with the firm's CashFlow Statement. Also, as explained below, the cash-basis IS reports exactly the same informationas the Operating section of WEA's Cash Flow Statement, making it redundant. So once again weconclude that the Accrual Accounting report is superior to its cash-basis alternate.

Cash Flow Statements

Cash-Basis and Accrual-Basis

Since the Cash Flow Statement only reports changes in cash, this report is the same in the CashAccounting and Accrual Accounting worlds. As you can see, the Operating section is identicalto the cash-basis Income Statement.


WHY BOTHER WITH CASH ACCOUNTING

Despite the drawbacks of Cash Accounting that we just highlighted, it is useful under somecircumstances and is used by many entities. It has the benefit of being simple to understand andquick to use, making it perfect for small, unleveraged service (consulting) entities with cash-likesales and small amounts of non-cash assets.

A good example of a firm for which Cash Accounting is better than Accrual Accounting is Valu-It LLC, a several-person appraiser in Manhattan. Value-It gets paid by cash or check on deliveryof its appraisals. The firm's main asset is the knowledge of its appraisers (which is not a GAAP-qualified asset). The entity does not own a car or a place of work, choosing instead to have itsemployees travel by subway and taxi, and to rent office space month-to-month. Valu-It has noloans or other significant liabilities except unpaid bills for monthly rent, etc.

In this case, savings to the firm in time and accounting expertise far outweigh any small benefitsof carefully tracking its monthly rent-related accruals. This is generally true for firms withmostly cash assets and few liabilities.

On the other hand, the more non-cash assets and liabilities an entity has, the better AccrualAccounting is for it. Firms benefiting from Accrual Accounting include virtually all industrialand financial entities, and service companies with large amounts of non-cash assets (like HCP)or liabilities (such as firms with significant borrowings).

The IRS requires that any C-Corporation with more than $5MM in revenue use AccrualAccounting. Similarly, the Securities and Exchange Commission (SEC) requires all filingentities to use Accrual Accounting.


COMPREHENSIVE ACCOUNTING

EXAMPLE

CHAPTER 11


AMERICAN COMMUNITY PROPERTIESEXAMPLE

Lets tie together almost everything we've learned about financial accounting into one big, real-world example.

Consider American Community Properties (APO), founded in 1997 and headquartered in St.Charles, MD. APO's primary business is the purchase, upgrading and reselling of detached andmulti-family homes. The company also owns multifamily, multistory buildings and rentsapartments in them.

As a home refurbisher and lessor, APO has characteristics of both industrial and servicecompanies. Its refurbishing business features the inventory assets of industrial firms, and itslandlord operations earn revenue through the service of providing habitable space.

Lets follow APO through the year 20X1. We will use its latest Balance Sheet, its 20X1economic events and additional information to create a full set of journal entries and financialstatements for the year. Here is everything we'll need:

Balance Sheet ($MM UON)APO, Inc. Year 20X0

AssetsCurrentCash $3,000Equip. Held for Sale $1,000

Long TermPPE $10,000- Accum. Deprec. -$5,000= PPE Book Value $5,000

Total Assets $9,000

Liabilities(All Long Term)Loan Payable $4,000Total Liabilities $4,000

EquityPIC $4,000RE $1,000Total Equity $5,000

Liabilities+Equity $9,000

Notes at BOY 20X1:

APO’s PPE has average useful life of 16 years, with $2,000MM salvage value. The firm's PPE has already accumulated, on average, 8 years of depreciation. APO uses linear depreciation. The loan shown on the 20X0 Balance Sheet carries an annual interest rate of 7%

(compounded annually). The principal is due to be repaid in 20X3.

CHAPTER11–COMPREHENSIVEACCOUNTINGEXAMPLE PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

The cumulative net income of the company, since inception, is $2,000.

20X1 Economic Events:

1. APO purchased inventory (homes) costing $34,000 on account. (IE: was invoiced at time ofpurchase).

2. Sold/invoiced $37,000 worth of homes to customers. (APO ‘matches’ certain expenses torevenue at the end of each accounting period, rather than with each sale).

3. Received $1,000 in cash prepayment for services it promises to deliver in 2008.4. Noted that its Cost of Goods Sold for the year was $30,000.5. Received $33,000 in payments on previously-submitted invoices.6. Paid $29,000 of outstanding vendor invoices.7. Noted need to pay and paid $5,000 to rent office space for the year and for other

administrative costs.8. Prepaid $3,000 for 20X2 office space rent.9. Noted depreciation on all its PPE assets.10. Noted and paid #20X1 # interest on its Loan Payable.11. Noted that $1,000 worth of inventory was destroyed and useless as inventory but retained

$500 in salvage value.12. Took out a loan for $5,000 and used this cash to purchase 100% of BabyRealty.

BabyRealty’s Balance Sheet (MV) at the time of sale was:PPE: $10,000, AP: $6,000, Equity $4,000

13. Sold its $1,000 Equipment Held for Sale for $700 cash.14. Estimated (noted) its 20X1 Tax Expense at $147.15. Paid its owners a dividend of $100.

RECORD JOURNAL ENTRIES FOR THE ECONOMIC EVENTSWe start solving this example by creating journal entries for the firm's 20X1 economic events.Journal entries for simple events that we have covered previously are listed without comment.Explanations are provided for new and more complicated events.

Speed Learning / Self Testing Tip:Before reading through this section, I strongly suggest that you try to create journal entries onyour own from the events listed above.

1. APO purchased inventory (homes) costing $34,000 on account (IE: was invoiced at time ofpurchase).dr Inventory $34,000 (A)cr AP $34,000 (L)

2. Sold/invoiced $37,000 worth of homes to customers. (APO ‘matches’ certain expenses torevenue at the end of each accounting period, rather than with each sale).dr AR $37,000 (A)


cr Revenue $37,000 (E)

3. Received $1,000 in cash prepayment for services it promises to deliver in 20X2.dr Cash $1,000 (A)cr Unearned Revenue $1,000 (L)The cash received is a liability until APO provides the promised services.

4. Noted that its Cost of Goods Sold for the year was $30,000.dr COGS Expense $30,000 (E)cr Inventory $30,000 (A)Here APO looks up its sales for the year, and matches its COGS Expense to the cost of theinventory that it sold during the year.

5. Received $33,000 in payments on previously-submitted invoices.dr Cash $33,000 (A)cr AR $33,000 (A)

6. Paid $29,000 of outstanding vendor invoices.dr AP $33,000 (L)cr Cash $33,000 (A)

7. Noted need to pay and paid $5,000 to rent office space for the year and for otheradministrative costs.dr SGA Expense $5,000 (E)cr Cash $5,000 (A)

Here we use SGA Expense because the event includes “other administrative costs.” Withoutknowing what the other admin costs are, we cannot specify these expenses more precisely.

8. Prepaid $3,000 for 20X1 office space rent.dr Prepaid Expense $3,000 (A)cr Cash $3,000 (A)

Prepaid Expense is an asset because, in our assumed loving world, APO could ask for arefund for the prepaid rent before it used the office space. We also assume that, as the year20X1 progresses, APO could ask for a refund for any unused rent payment. So, the prepaidassets declines linearly to the value of zero at the end of 20X1.

9. Noted depreciation on all its PPE assets.dr Depreciation Expense $500 (E)cr Accumulated Depreciation $500 (contra A)

The $500 is calculated as follows:

$500 = ($10,000 total PPE) - ($2000 salvage value) (16 years)

10. Noted and paid20X1 interest on its Loan Payable.


dr Interest $280 (E)cr Cash $280 (A)

The $280 is computed from:

280 = 7% of 4,000 loan balance at BOP.

11. Noted $1,000 worth of inventory was destroyed and useless as inventory but retained $500in salvage value.dr Misc. Asset (from Inventory) $500 (A)dr Inventory Write-Down $500 (E)cr Inventory $1,000 (A)

As always, when an asset is written down, the net amount written off is taken as a Write-Down or Write-Off Expense. In this case, $500 worth of the inventory will be sold to asalvager. The $500 write-down could be attributed to either Inventory Write-Down orCOGS Expense. As we have learned previously, it is preferable to use inventory write-down (to provide readers with more specificity), and GAAP suggests that all large inventorywrite-offs should be explicitly called out and not folded into COGS.

12. On the last day of the year, APO took out a long-term loan for $5,000 and used this cash topurchase 100% of BabyRealty. BabyRealty’s Balance Sheet (market value basis) at the timeof sale was:

PPE: $10,000, AP: $6,000, Equity $4,000.

First take out the loan:dr Cash $5000 (A)cr Loan (long-term) $5000 (L)

Then take ownership of BabyRealty, and absorb the firm's accounts into those of APO's:dr PPE $10,000 (A)dr Goodwill $1,000 (A)cr AP $6,000 (L)cr Cash $5,000 (A)

When APO buys BabyRealty, it takes on all of this firm's assets (marked to their marketvalues) and liabilities. We see this from the PPE and AP entries above. APO also paysBabyRealty's prior owners as seen in the credit to cash. At this point total debits are lessthan total credits by $1,000. This amount, representing the amount paid for BabyRealtyover the market value of its equity, is ascribed (as always) to APO's Goodwill account.

An example showing how to establish Journal entries for a more general-case merger, wherethe purchased firm has cash on its balance sheet, is given at the end of this chapter.

Good to Know:When evaluating APO's future Balance Sheets, many value investors will set the firm'sGoodwill amount to zero, on the assumption that APO overpaid for BabyRealty by thisamount. A significant body of academic research supports the view that purchasers usuallyoverpay for the firms they buy.


13. Sold its $1,000 Equipment Held for Sale for $700 cash.dr Cash $700 (A)cr Equipment Held for Sale $1,000 (A)cr Loss on Sale of Equipment $300 (E)

Here the difference between the equipment's book value (or “holding value”) and sale pricerealized is ascribed to equity in the Gain on Sale or Loss on Sale account. In this case, Losson Sale is the proper account because the realized sale price was less than the holding value.

Gain or Loss on Sale will appear on APO's Income Statement in the Other Revenue/Expensesection. The cash of $700 will be an Investing flow on APO's Cash Flow Statement, as theitems sold was equipment, presumably retired from APO's PPE.

14. Estimated (noted) its 20X1 Tax Expense at $147.dr Income Tax $147 (E)cr Accrued Tax $147 (L)

15. Paid its owners a dividend of $100.dr Dividend $100 (E)cr Cash $100 (A)

Here is the complete set of journal entries:


CREATE THE EOY 20X1 BALANCE SHEETAs you (hopefully) recall, a Balance Sheet shows the total balance for each account represented,including all journal entries from the inception of the firm. It is a level report (showing totallevels of each account), not a flow report.

A good way to start building a Balance Sheet is to create a table that includes all the BOPbalances (IE: all the items shown on the 20X0 Balance Sheet), and all the account entries for theevents experienced in 20X1. The table's entries should be sorted first by assets, liabilities andequity, then by account. For each account with a BOP balance, the BOP balance should be thefirst entry.

Speed Learning / Self Testing Tip:For this Balance Sheet and all of APO's other 20X1 financial statements, you shouldindependently complete each step needed to create the statement, then check your results withthe information shown here.

Here is the completed table, with BOP balances called out and written in blue:


Working from this table, we easily complete the Balance Sheet by:

Subtotaling each asset and liability account. Subtotaling revenue, expenses and dividends into Retained Earnings, and adding this

amount to this account's BOP balance. Writing our results out in Balance Sheet format. Checking that the Fundamental Accounting Equation:

Total Assets = Total Liabilities + Total Equityholds true for this new, 20X1 Balance Sheet.

Here is the completed Balance Sheet:

As always, Balance Sheet format includes the display of the entity's name, the declaration thatthe report is indeed a Balance Sheet with the accounting period, and the currency units utilized.“UON” stands for “Unless Otherwise Noted.” It is not necessary to lay out assets in a separatecolumn from liabilities and equity. I chose a two-column layout in this case simply for its fit onthe page.

CREATE THE 20X1 INCOME STATEMENTIncome Statements (like Cash Flow Statements and Statements of Owners' Equity) are flowreports, that focus primarily on changes during the accounting period being reported. IncomeStatements do not show BOP or EOP balances at all.


We can quickly create a 20X1 Income Statement for APO from the above table that wedeveloped for APO's 20X1 Balance Sheet. Note that in the equity section, all of APO's revenueand expenses for 20X1 are listed. Here is the equity portion of the table, with non-IncomeStatement entries crossed out:

Recall that BOP balances are not shown onIncome Statements and dividends are notexpenses. Therefore these entries arecrossed out.

In general, to create APO's Income Statement, we simply subtotal the Income Statement items byaccount and rewrite this information in Income Statement format. In this example, nosubtotaling is required.

Here is APO's Income Statement for 20X1:


Here “Loss on Sale” is set in its own section, “Other Expense.” This is considered good practice,and is a practice you should follow.

Also, I've subtotaled by “EBIT,” which stands for “Earnings Before Interest and Tax.” Thissubtotal is not required for Income Statements, but it is fairly common. Other common subtotalsinclude “EBT” (Earnings Before Tax) and EBITDA (Earnings Before Interest, Tax, Depreciationand Amortization).

Finally, this Income Statement, like most, does not employ an algebraic sign convention. Thereader is expected to know that expenses are subtracted from revenues.

CREATE THE OWNERS’ EQUITY STATEMENT (OES)We can again use the table we created for the Balance Sheet to complete an Owners' EquityStatement for APO. Here is the equity portion of the Table, showing revenue and expensescondensed into Net Income:

To build the OES, we also must divide the BOP Retained Earnings into its Net Income andDividend components. Recall that:

Retained Earnings ≡ Net Income – Dividends

Also, we are told that APO's cumulative Net Income through 20X0 is $2,000. Using this and theBOP Retained Earnings in the table of $1,000 yields:


Retained Earnings ≡ Net Income – Dividends$1,000 = $2,000 – Dividends issued through BOP

From which Dividends through BOP = $1,000.

With this information and APO's BOP Balance Sheet, we have everything we need to create thefirm's 20X1 Owners' Equity Statement.

Here is the statement in OES format:

After creating the statement, the first thing we should check is that the EOP equity balancematches the Equity balance on APO's 20X1 Balance Sheet. $5,173K is in fact the amount on theBalance Sheet. Also note that:

BOP balances are taken from APO's BOP Balance Sheet and the above calculation for BOPdividends.

Each row is totaled into the equity column, and each column is totaled into the EOP Balancerow.

The $5,173 total of the EOP Balance row entries matches the total of the equity columnentries.

The EOP balances for PIC and NI + Div match the PIC and Retained Earnings numbers onAPO's 20X1 Balance Sheet.

CREATE THE (DIRECT METHOD) CASH FLOW

STATEMENT (CFS)To create APO's 20X1 direct method Cash Flow Statement, we must work from its journalentries (or transaction table entries) for the period. Our process starts by finding each cash entry,


noting the reason that cash flowed, and designating the flow as Operating, Investing orFinancing.

Here are the journal entries with cash transactions highlighted according to their type. Operatingflows are shown in red, Investing in green, and Financing in blue.

The next step is to sort by Operating/Investing/Financing, to subtotal by reason for flow, and toreplace the dr/cr indicators with algebraic + and – signs.


For each flow, I've replaced the account reported in the journal entry with the reason for the cashflow. So for example, the $1,000 cash inflow associated with Unearned Revenue (Event 3) hasbeen labeled “Advances from Customers.” There is no exact rule labeling each flow. Anydescription that reasonably describes why cash moved in or out is fine. (The description of theeconomic event that precipitated a cash journal entry's creation is usually a fine explanation for acash flow).

As our last step, we put the above information, along with APO's BOP and EOP cash balances,into Cash Flow Statement format:

The BOP cash balance is taken from APO's 20X0 Balance Sheet. The EOP balance is checkedagainst the cash shown on the firm's EOP Balance Sheet.


PURCHASING ENTITIES WITH CASH ON THEBALANCE SHEET

Consider this purchase:

M & I Homes (MHO, a competitor of CTX and APO) takes out a (long-term) loan for $4,000and uses this cash to purchase 100% of NicheRealty. The transaction is completed on the lastday of the year.

NicheRealty’s Balance Sheet (with assets at market values) at the time of the transaction is asfollows:

Assets Liabilities and Equity

Cash: $1,000 AR: $1,000 PPE: $6,000

AP: $6,000

Equity: $2,000

Find journal entries, an Income Statement and a Cash Flow Statement for this purchase.

Solution:

Journal Entries:

1. Take out the loan:

dr Cash $4,000 (A) (a Financing Cash Flow)cr Loan Payable $4,000 (L)

2a. Get NicheRealty’s Assets (at market values) and Liabilities, and establish Goodwill:

dr Cash $1,000 (A) (An Investing CF)dr Accounts Receivable $1,000 (A)dr PPE $6,000 (A)dr Goodwill $2,000 (A) (Price paid - Equitymv)cr Accounts Payable $6,000 (L)

The acquisition of cash is an Investing flow because its an asset being purchased along withthe rest of NicheRealty's assets. This amount cannot be used to reduce the loan taken to buythe company, because it is being used to support NicheRealty's daily operations. Think ofthis as cash held in NicheRealty's cash registers and petty-cash jars.

2b. Pay for NicheRealty:

cr Cash $4,000 (A) (An Investing CF)


Income Statement:(for the Accounting Period covering just this transaction):

Revenue $0.0Expense $0.0

No normal, day-to-day business occurred during the period.

Cash Flow Statement:(for the Accounting Period covering just this transaction):

Cash Flow from Operations $0.00

Cash Flow from InvestingAcquisition of NicheRealty ($3,000)

Cash Flow From FinancingLoan Proceeds $4,000

The Cash Flow from Investing is computed as follows:

Cash Asset Obtained in Acquisition $1,000- Cash Paid for Acquisition ($4,000)= Net Cash Flow from Acquisition of NicheRealty ($3,000)

An alternate representation of the Cash Flow from Investing is:

Cash Flow from InvestingPayment for Purchase of NicheRealty ($4,000)Cash of NicheRealty's Obtained in Purchase $1,000

Either representation is OK. The second method may be considered preferable, because itprovides more information and facilitates matching of the Loan Proceeds to the Payment forPurchase.


SOURCES AND USESAND

THE INDIRECT CASH FLOW STATEMENT

CHAPTER 12

CHAPTER12–SOURCESANDUSES,ANDTHEINDIRECTCASHFLOWSTATEMENT PAGE1Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

CASH ANALYSIS

In the world of accounting and finance, cash is truly king. Cash matters because we use it tomeasure value, to predict whether a company will declare bankruptcy, to gauge the safety of acompany and to determine countless other financial metrics.

Cash analysis often begins with with several straightforward questions, such as:

How much cash does a company have relative to its needs?

What are the entity's sources of cash?Its operations? Equity and/or debt financing?

What is the company using cash for?Supporting unprofitable operations? Purchasing PPE or other entities? Repaying loans?Paying dividends? Buying back its stock?

How does the company's current cash management compare to its history or to comparablecompanies (“comps”)?

CASH ANALYSIS TOOLSThe primary tools for cash analysis include the following:

1. Cash Ratio AnalysisCash ratios compare a company's cash levels or flows to items drawn from its financialstatements. For example, the Cash-Level Ratio is defined as:

(Cash and Equivalents)EOP / Sales.It measures how much cash a company is keeping on hand relative to its sales.

2. Sources and Uses TablesThese useful tables categorize changes to an entity's Balance Sheet in a period as “Sources”or “Uses” of cash.

3. Cash Flow StatementsAs we know, there are two main types of cash flow statements – the Direct MethodStatement, which we have learned to create, and the Indirect Method Statement, which wewill cover in this chapter.

In this chapter, we will look at Sources and Uses Tables and Indirect Cash Flow Statements.Cash Ratio Analysis is covered in the next chapter.


SOURCES AND USES TABLES

Sources and Uses Tables (SUs) provide a quick way to see where a company is getting its cashand how it is using it. They supply a list of cash “Sources” and a corresponding register of cash“Uses” in a given accounting period. “Sources” and “Uses” are in quotes because they are notexactly the same as cash inflows and outflows. Instead, “Sources” and “Uses” are defined as:

A Source of cash ≡A decrease in an asset account, or an increase in a liabilities or an equity account.

A Use of cash ≡An increase in an asset account, or a decrease in a liabilities or an equity account.

Sources represent actual or committed inflows of cash. Another way of saying this is thatSources bring in cash or bring a commitment to obtain in cash in the future. The cash orcommitment is secured by decreasing an asset account or increasing a liabilities or an equityaccount.

I remember all this by noting that a sale of (say) PPE provides cash and reduces the PPE assetaccount. Likewise, an increase in a loan draw yields cash and increases the Loan PayableLiability Account.

Uses are the opposite of Sources. Uses measure actual or committed outflows of cash. The cashor commitment is employed for increasing an asset account or reducing a liabilities or an equityaccount. For example, when a firm uses cash or a cash commitment to purchase a building, itsPPE Asset Account increases. When the firm employs cash to pay down a loan, its Loan PayableLiability Account decreases.

A key point to remember (as noted above) is that Sources and Uses are not necessarily actualcash flows. They are either cash flows or commitments to pay or receive cash in the future.

CONSTRUCTING SOURCES AND USES TABLESSUs are based on changes in an entity's Balance Sheets between two periods. SUs are oftenconstructed from Balance Sheets, but they can also be created from a Transaction Table or set ofjournal entries.

Because SUs are constructable from Balance Sheets alone, they are particularly helpful whenjournal entries or Transaction Tables are unavailable. This situation is common in the real worldanalysis of public companies.

Sources and Uses Tables are created as follows:

1. For the accounting period of interest, obtain the changes to each Balance Sheet account. (IE:Obtain a set of ΔBalance Sheet entries). The changes can be obtained in two ways:


a) By subtracting BOP Balance Sheet values from EOP values.

For example:ΔAR = AR(EOP) – AR(BOP)where as usual “Δ” is short for “change in.”This is the easiest method to use when you are given BOP and EOP Balance Sheets.

b) By working directly from Transaction Table entries or journal entries.Using the above example, ΔAR would have originated from a journal entry such as:dr AR (A)cr Revenue(A)

This is the best method to use when you are given a set of economic events, a TransactionTable or journal entries, but not BOP and EOP Balance Sheets. In these cases TransactionTable or journal entries are ΔBalance Sheet items. The entries should be subtotaled byaccount, as if you were going to construct an EOP Balance sheet.

2. Identify the ΔBalance Sheet entries as Sources or Uses of cash.3. Put the categorized entries into Sources and Uses Table format, and check that

Sources = Uses.

Note that the Duality Concept still holds for the sorted ΔBalance Sheet entries. After sorting, itis stated as “Sources = Uses,” instead of ΔAssets = ΔLiabilities + ΔEquity.Note also that Sources = Uses says nothing about total Sources equaling total ΔAssets.Generally total Sources and total Uses will not equal ΔAssets or ΔLiabilities plus ΔEquity.

EXAMPLE 1 – GREEN CAR COMPANY:Consider a short accounting period for Green Care Company (GCC) soon after the firm startedoperations. The firm's Balance Sheet at the beginning of the period was:

Cash $100K, Equity (Retained Earnings) $100K

During the period, GCC experienced the following events:a) Received a $50K loan.b) Raised $50K in Equity capital.c) Bought a CNC mill for $150K, paying cash.

Find a Sources and Uses Table for the period.

Solution:1. Build a set of ΔBalance Sheet (ΔBS) entries for the period.

Since only GCC's BOP Balance Sheet is available but its economic events are given, we shouldwork from the economic events. Here is a Transaction Table assembled from the period's events.It provides all the ΔBS information for the period:

Event ΔAssets = ΔLiabilities + ΔEquity

a. Cash $50K Loan $50K


b. Cash $50K PIC $50Kc. Cash ($150K)

Mill (PPE) $150K

2. Identify the ΔBalance Sheet entries as Sources or Uses of cash.

Here we simply label each ΔBS entry in the above Table as a Source or Use, remembering:

Increases (decreases) in Assets are Uses (Sources).

Increases (decreases) in Liabilities and Equity are Sources (Uses).

Here is the labeled Table, with Sources and Uses shown in red:

Event ΔAssets = ΔLiabilities + ΔEquity

a. Cash $50K (U) Loan $50K (S)b. Cash $50K (U) PIC $50K (S)c. Cash ($150K) (S)

Mill (PPE) $150K (U)

Note that changes to cash are handled just like any other asset account. An increase of cash in aUse and a decrease is a Source.Here is a good way to think of this:

Consider GCC's cash as funds held in a money-market account or in a cash register. Think of thecash in the money market or the cash register as funds stored in GCC's “Cash Account.” Withall this in mind, GCC can Source cash by withdrawing from its Cash Account. It can also Usecash by depositing into its Cash Account.

3. Put the categorized entries into Sources and Uses Table format, and check thatSources = Uses.

Here is the formatted Table:

Sources and Uses TableGCC, for the Period

Sources:Δ Cash Account $50KΔ PIC $50KΔ Loan $50KTotal Sources $150K

Uses:Δ Mill (PPE) $150KTotal Uses $150K

Check: Total Sources = Total Uses

At the risk of beating this example to death, lets show that we would get the same result byworking from GCC's BOP and EOP Balance Sheets.

Recall the BOP Balance Sheet:


Cash $100K, Equity (Retained Earnings) $100K

From this and the above Transaction Table for the period, we create GCC's EOP Balance Sheet:

Account BOP + Δ = EOP

AssetsCash Account $100+$100-$150 = $50KMill (PPE) $0 + $150 = $150KTotal Assets $200K

LiabilitiesLoan $0 + $50 = $50K

Owners’ EquityRE $100 + 0 = $100KPIC $0+50 = $50KLiabilities + Equity $200K

Now we obtain ΔBalance Sheet entries for all accounts by subtracting BOP Balance Sheet valuesfrom EOP values. Here is the result, with the ΔBS entries also labeled as Sources or Uses:

Account EOP - BOP = ΔΔCash Account = $50K - $100K = -$50K (S)ΔMill = $150K - $0K = $150K (U)ΔAssets = $100K

ΔLoan = $50K - $0K = $50K (S)ΔRE = $100K- $100K = $0KΔPIC = $50K - $0K = $50K (S)Δ (Liabilities + Equity) = $100K

The Sources and Uses are the same as we obtained by working directly with the TransactionTable entries. Notice also that

ΔAssets = ΔLiabilities + ΔEquity = $100K, and

ΔSources = ΔUses = $150K, but

ΔSources ≠ ΔAssets, and ΔUses ≠ Δ(Liabilities + Equity).

Interpretation of the Sources and Uses Table:Recall GCC's Sources and Uses Table:

Sources and Uses Table


GCC, for the Period

Sources:Δ Cash Account $50KΔ PIC $50KΔ Loan $50KTotal Sources $150K

Uses:Δ Mill (PPE) $150KTotal Uses $150K

Check: Total Sources = Total Uses

The table tells us how GCC generated cash in the period, and what it used this incoming cash for.GCC Sourced (obtained) cash by:

Withdrawing from its Cash Account. Taking out a loan. Raising funds from equity investors.

The company Used this cash to buy a mill.

EXAMPLE 2 – GREEN CAR COMPANY AGAIN:Consider another brief accounting period for GCC. During the period, the company buys $5K ofinventory and receives an invoice for it. Nothing else happens. create a Sources and Uses Tablefor the period, and explain its entries.

Solution:The Sources and Uses for the period are:

∆ Inventory $5K(U)∆ Accounts Payable (AP) $5K (S)

The corresponding Sources and Uses Table is:

Sources and Uses Table GCC, for the Period

Sources: Uses:Δ AP $5K Δ Inventory $5K

The interpretation of this Table is not as obvious as for the previous example. Notice that nocash actually flowed in the period. In this case, we explain the table as follows: GCC Sourced$5K by committing to pay a bill in future, as shown by the increase in its Accounts Payable. Thecompany Used this commitment to obtain $5K of Inventory.

GENERAL INTERPRETATION OF SOURCES AND USESWhether cash flowed or was committed to flow, Sources and Uses Tables tell us:


§ How a company Sourced cash (or the commitment of cash) by decreasing its assetsand/or increasing its liabilities and equity.

§ How the firm Used this cash (or the commitment of this cash) to increase its assets and/ordecrease its liabilities and equity.

Sources and Uses are often discussed without explicitly including the phrases in parenthesis. Inthese cases it is assumed that a “Source” (for example) is either an inflow of cash or acommitment to receive cash in the future. This is consistent with our definitions of Sources andUses.


THE INDIRECT METHODCASH FLOW STATEMENT

The Indirect Cash Flow Statement is arguably the most common method used to understandentities' cash management practices and cash positions. Its mission in life and its key attributesare identical to those of the Direct Method Cash Flow Statement.

As a reminder, the mission of a Cash Flow Statement is to report the movement of cash to andfrom a firm over an accounting period. The Statement's key attributes are:

Satisfying:Cash(BOP) + ΔCash = Cash(EOP)

Sorting cash flows into these three groups:1. Cash flows from Operations (Operating-Cash-Flows)2. Cash flows from Investing3. Cash flows from Financing

The three cash flow groups are defined as follows:

1. Cash flows from Operations are Income Statement related flows. These include any cashinflow or outflow from:

A firm's day-to-day production and sale of products or services. Examples include: Paying for inventory. Receiving cash from product or service sales. Paying suppliers and employee salaries. Paying loan interest and taxes.

2. Cash flows from Investing are any non-Operating cash flows involving the investment of afirm’s resources with 3rd parties. These include for example:

§ The purchase or sale of PPE.

§ The purchase or sale of another firm’s stock or bonds.(Unless the Cash Flow Statement is being prepared for an entity in the business of tradingstocks and bonds).

§ Making loans, or receiving repayment of loan principal.

3. Cash flows from Financing are non-Operating cash flows to or from a firm’s stakeholders.(IE: cash flows to or from the entity's owners {shareholders} and lenders).Examples include:

§ Taking out a loan or repaying its principal.

§ Issuing a bond, or repaying a bond's principal.


§ Issuing stock (+PIC) or repurchasing stock (-PIC).

§ Distributing dividends.

REVIEW: THE DIRECT METHOD OF CREATING

CASH FLOW STATEMENTSRecall Cash Flow Statements are created with the Direct Method as follows for a givenaccounting period:

Locate all the changes to cash in the period's journals or Transaction Table entries.

Note the reason for each cash flow, and categorize it as Operating, Investing or Financing.

Format the categorized entries into Direct Method Cash Flow Statement format. IncludeBOP and EOP cash balances from the appropriate Balance Sheets. Check that:

Cash(BOP) +Δ Cash(Cash Flow Statement) = Cash(EOP, as reported on BS)

INDIRECT CASH FLOW STATEMENT OVERVIEWThe Indirect CFS takes a different approach. Instead of starting with cash journal or TransactionTable entries, it begins with the record of all account changes in a period. Also, in its Operatingsection, the Indirect Statement highlights Net Income (NI) as computed on the period's IncomeStatement. The resulting Cash Flow Statement includes Sources and Uses of cash, as definedearlier in this chapter.

We will consider two variants of Indirect Cash Flow Statements – “Pure” and GAAP. First wewill develop what I call “Pure” Statements, then use these to create GAAP Statements.

Indirect Cash Flow Statements are derived by first rearranging and expanding the FundamentalAccounting Equation, to isolate ΔCash and highlight Net Income in the period (ΔNI).

Start with:Δ Assets = ΔLiabilities +ΔEquity

Rearrange and Expand to identify Δ Cash and ΔNI:Δ Cash + Δ All Other Assets = ΔLiabilities + Δ PIC + Δ Div + ΔNI

Isolate Δ Cash and highlight ΔNI:Δ Cash = ΔNI - Δ All Other Assets + ΔLiabilities + Δ PIC + Δ Dividends a)

Next, the right-hand side of equation a) is expanded and rearranged into Operating, Investing,Financing sections, with ΔNI becoming the first term in the Operation section.

Note that, in equation form, a Direct Method Cash Flow Statement can be expressed as:


Δ Cash = Σ (Cash Account journal entries in period) b)

By comparing and contrasting a) and b) we see:

§ ΔCash a) = ΔCash b) = total cash flow in period. (A true cash flow).

§ Each right-hand side entry of b) is a cash flow.

§ Each right-hand side entry of a) is not necessarily a cash flow.However, each RHS entry of a) is always a Source or a Use of cash.

HOW TO CREATE A PURE, INDIRECT METHOD

CASH FLOW STATEMENT

I. Operating Cash Flow SectionTo build the Operating portion of the Indirect Cash Flow Statement, we expand, isolate andrearrange some terms of equation a):

ΔCash = ΔNI - Δ All Other Assets + ΔLiabilities + Δ PIC + Δ Dividends a)

After making these algebraic changes, we have

Operating Cash Flow ≡

NI for period (Δ NI)

+/- portions of ΔAll Other Assets and ΔLiabilities from a), needed to convert from ΔNI to

“Cash-Associated Income” 22j)

+/- Sources/Uses from working capital accounts in a). 31q)

So far so bad. Now we have a crazy, complicated definition of Operating Cash Flow thatincludes two new, as-yet-undefined terms: “Cash-Associated Income” and “working capitalaccounts.” At this point, you may be asking how we could possibly need such a convoluteddefinition. There are actually three reasons for defining Operating Cash Flow like this. Two ofthem are pretty good:

Reason 1:"Accountants like confusion because it keeps us in business."As stated by Kenneth E. Baggett, Co-CEO CohnReznick Accountants, during an interview onBloomberg radio.

Reason 2:If we define the Indirect Method Operating Cash Flow (OCF) in this way, then


Indirect Method OCF = Direct Method OCF

This is exactly what we want. Any method we use should provide the same total Operating CashFlow as the Direct Method.

Reason 3:By defining Indirect Method Operating Cash Flow in this way, we highlight the differencesbetween Operating Cash Flow and Net Income. This is very helpful because it shows how off afirm's Net Income is from its Operating Cash Flow, and why the two numbers are different. Allthings being equal, we'd like to see Net Income be as close to Cash From Operations as possible.

Lets define “Cash-Associated Income” (or simply “Cash Income”) and “Sources/Uses fromWorking Capital Accounts,” and then compute Indirect Method Operating Cash Flow for anexample company.

Cash Associated Income (Cash Income)≡ ΔNI minus the effect of components unassociated with ΔCash, except for inventory-relatedexpenses.

Inventory-related expenses include COGS and Inventory Write-Downs. We will account forinventory-related items later, when addressing “Sources/Uses from Working Capital Accounts.”(See line 31q in the definition of Operating Cash Flow).

Components of ΔNI that are not associated with changes to cash are:

Any component of ΔNI (except inventory-related expense) whose corresponding (“other side”)journal entry could not be ΔCash.

Components of ΔNI in this category include, for example:

Depreciation Expense. PPE Write-Down Expense. Gain/Loss on Sale.

In each case, the other side of the originating journal entry is never cash.

Working Capital Accounts are defined as follows:

Working Capital Accounts≡ All Current Balance Sheet accounts, not associated with financing or investment+ any Non-Current BS accounts associated with day-to-day business.

Examples of Working Capital Accounts are:

AR (Accounts Receivable) Inventory AP (Accounts Payable) Pre-paid Expenses (even if non-current)

These are not Working Capital Accounts:


Short-term portion of Long Term Debt Ownership of third-party stock

(unless the firm's business is stock trading)

When recording economic events, care should be taken not to record Investing or Financingtransactions in Working Capital Accounts. For example, say a firm buys a 3-D printer for$5,000 and receives an invoice for the purchase. The entity may record the event as follows:

dr PPE (3D printer) (A)cr AP (L)

In this case the firm's next Indirect Cash Flow Statement will erroneously show the increase inAP as an Operating use of cash. To avoid this error, firms typically split AP into two or moreaccounts. “AP, Trade” for example, is often used as a Working Capital Account; “AP,Investing” may be used for recording purchase or sale of small-ish PPE items. Throughout thistext, “AP” is assumed to be a Working Capital Account that contains only Operating items,unless an exception is specifically identified.

In a given accounting period, a Source of cash from the Working Capital accounts is an increasein a Working Capital liability or a decrease in a Working Capital asset. Likewise, a Use of cashfrom the Working Capital accounts is an increase in a Working Capital asset or a decrease in aWorking Capital liability.

Working Capital is another useful item that you should probably learn about now. WorkingCapital is derived from a firm's Working Capital Accounts and is defined as follows:

Working Capital≡ Working Capital Assets – Working Capital Liabilities

Working Capital is a measure of an entity's cash and how much cash entity's operations shouldconvert to cash, minus how much the entity's operations will have to pay out in cash. For ahealthy company, Working Capital should generally greater than zero.

INDIRECT CASH FLOW EXAMPLE 1:OPERATING CASH FLOW FOR SMALLCO

Consider the Transaction Table for SmallCo's 20X1 economic events:


Find cash flow from Operations via the Indirect Method.

Solution:First note that ΔCash for the year = $355. Next, create a Direct Method Cash Flow Statement forthe firm, using the cash entry inspection method we've already learned:

Lets also create SmallCo's Income Statement for the year, by working from the ΔEquity entriesin the last column of the Transaction Table:


Now we are ready to determine the Cash Flow from Operations section of SmallCo's IndirectCash Flow Statement. The steps are as follows:

A) Re-arrange and expand the terms in the Transaction Table to isolate ΔCash andhighlight ΔNI.

First we transform the Transaction Table columnsfrom: Δ Assets = Δ Liabilities + Δ Equityto: Δ Cash = ΔNI - ΔAll Other Assets + ΔLiabilities + Δ PIC + Δ Div a)

Then we compress all the components of ΔNI into single entry: ΔNI = 295 (as shown onSmallCo's Income Statement). Next we similarly total all changes to cash, leavingΔCash Total = 355.

Here is the resulting, adjusted Transaction Table;

Note that ΔCash is still = to ΔEverything Else. This assures us that the Fundamental AccountingEquation is still satisfied.

B) Further Re-Arrange the Table to isolate Cash Flow from Operations

Recall that:

Indirect Method Operating Cash Flow ≡ 55h)

Net Income for period (ΔNI)


+/- portions of ΔAll Other Assets and ΔLiabilities from equation a), needed to convertfrom ΔNI to “Cash-Associated Income”

+/- Sources/Uses from Working Capital Accounts in equation a).

To isolate and subtotal Operating Cash Flow, we add columns to the Transaction Table forCash Associated Income and Sources/Uses from Working Capital Accounts. With thesemodifications, the Transaction Table looks like this:

Note that I've combined the ΔLiabilities and Other ΔAssets into one column, to keep the Table ata manageable size. Also, as usual ΔCash is still equal to ΔEverything Else, which ensures thatthe Fundamental Accounting Equation is still satisfied.

C) Compute Cash-Associated Income

Now we want to populate the ΔCash-Associated Income column. Recall that:

Cash Associated Income ≡ 42p)ΔNI less effect of components unassociated with ΔCash,except for inventory-related expenses.

And components of ΔNI unassociated with ΔCash are those whose “other side” TransactionTable entries (or journal entries) could not have been a change to cash.

We'll use SmallCo's Income Statement to find components of Net Income that could not haveeffected cash:


Lets consider each item shown on the Income Statement:

1) Revenue $500K (A)

Journal entries for this could have been:

dr Cash $500K (A)cr Revenue $500K (A)-- or --dr AR $500K (A)cr Revenue $500K (A)

Self Testing Tip:What is the 3rd possible type of Revenue entry?

Clearly, Revenue can always be associated with ΔCash. (IE: The “Other side” of its journalentry {or Transaction Table entry} entry could be ΔCash). So we will not make any adjustmentsto the Revenue component of ΔNI.

2) COGS Expense $50K

As an inventory-related expense, COGS is by definition an item that we do not adjust to computeCash Associated Income. {See 42p) above}. We will therefore not make an adjustment toCOGS.

3) Depreciation $25K

The associated journal entry for Depreciation Expense is:

dr Depreciation Expense $25K (L)cr Accumulated Depreciation $25K (L)

Neither side of this entry could have altered cash. So in this case we must adjust (or “back out”)the effect of Depreciation Expense.

We do this by moving the other side of the Depreciation Expense Transaction Table entry to theΔCash-Associated Income column of the Table.

Here is the Transaction Table shown first with the other side entry (Accumulated Depreciation)identified, then with this entry moved into the ΔCash-Associated Income column. Notice thatonce we have moved the entry, the effect of depreciation is removed from Net Income (ΔNI).(IE: -25K Depreciation Expense + 25K Accumulated Depreciation = 0).


This re-arrangement of terms is generally called “backing out” or “canceling out” the effect ofnon-cash expenses. You should convince yourself that the backing out is algebraically correct,and that ΔCash is still equal to ΔEverything Else in the second version of the Table .

Now we continue reviewing the components of ΔNI for Cash-Unassociated Items:

4) PPE Write-down Expense $35KThe associated Journal entry for this is:

dr PPE Write-down Expense $35K (L)cr PPE $35K (A)

As neither side of this entry could have affected cash, the PPE Write-Down Expense must becanceled to get to Cash Income.


5) Loss on Sale $15K.

This one is a little tricky. From the original Transaction Table (Event 4), we see the assetaccount was held at $20K but sold for only $5K. In this case, as in all Gain (Loss) on Saleentries, we break the event into cash and non-cash pieces. Here is how to break-up the event:

Cash part of sale:dr Cash (or AR) $5K (A)cr Asset Held for Sale $5K (A)

Non-cash part of sale:dr Loss on Sale Expense $15K (E)cr Asset Held for Sale $15K (A)

From this we see that neither side of the “non-cash part” could have affected cash. So we willback out effect of the non-cash part. (IE: We back out the $15K Loss on Sale amount). Ouranalysis and actions would be analogous situation for a Gain on Sale.

6) Accrued Interest $30K - and -

7) Income Tax $100K

The journal entry associated with the Interest Expense item could be:dr Accrued Interest Expense $30K (L)cr Cash $30K (A)

As this expense could have affected cash, we will not back it out.

The analysis for Income Tax Expense is similar. This entry is also left unadjusted.

Here is the Transaction Table with all the changes we've made to compute Cash-AssociatedIncome:

SmallCo's ΔCash Associated Income of $310 measures its Net Income of $235 less the effect ofits non-cash expenses. $310 is not equal to the firm's Cash From Operations, because thisamount does not include the impact of Working Capital Sources and Uses (which we will covernext).


Note that, of the $20 of Equipment for Sale recorded in ΔLiabilities – ΔOther Assets $15 hasbeen moved to back out SmallCo's $15 non-cash Loss on Sale. $5 remains in ΔLiabilities –ΔOther Assets, as shown in green. Also, as usual, after making these adjustments ΔCash is stillequal to ΔEverything Else. This ensures that our algebra is correct.

Summary of Cash-Associated Income Adjustments:Common items seen on Income Statements that must be “backed out” of Δ NI to get Cash-Associated Income include: Depreciation Amortization

(Essentially depreciation of intangible assets) Asset write-downs (except inventory) Gain or Loss on Sale.

This is a comprehensive list for problems tackled in this book. You can identify other items toback out on virtually any Income Statement by asking for each entry “could the associatedjournal entry include cash?” If the answer is no, then follow our process above to remove theimpact of the non-cash item.

D) Get Sources and Uses from the Working Capital Accounts

To complete the Operating portion of SmallCo's Indirect Cash Flow Statement, our final task isto tally Sources and Uses of cash from changes to the Working Capital Accounts.

Recall the definition of Working Capital Accounts and Working Capital:

Working Capital accounts≡ All Current Balance Sheet accounts, not associated with financing or investment+ any Non-Current BS accounts associated with day-to-day business.

Working Capital≡ Working Capital Assets – Working Capital Liabilities

Also recall that Sources of cash from the Working Capital Accounts are increases in WorkingCapital liabilities or decreases in Working Capital assets. Similarly, Working Capital Uses ofcash are increases in Working Capital assets or decreases in Working Capital liabilities.

To assemble SmallCo's Sources and Uses from its Working Capital Accounts, we first scan theremaining Δ Liabilities / Other Δ Assets sections of its Transaction Table for ΔWorking Capitalaccounts. Next we flag each ΔWorking Capital Account as a Source or a Use, as shown belowin red.


Our last step is to move the Sources and Uses to the Working Capital Sources/Uses column ofthe Transaction Table, as shown here:

Now SmallCo's Cash from Operations is equal to the total of the ΔCash Associated Incomecolumn plus the ΔWorking Capital column. (Yahoo). Note that the total ($400) matches theamount computed in SmallCo's Direct Method Statement.

E) Put Results in Indirect Cash Flow Statement Format

Here are the components of SmallCo's Operating Cash Flow, as they will be shown on itscomplete Indirect Cash Flow Statement.

For comparison, here is the Operating portion of SmallCo's Direct Method Statement.


Good to Know:The “+/- Working Capital Sources and Uses” section of SmallCo's Transaction Table can bealternately presented as “-ΔWorking Capital (except ΔCash).” Here is how and why this works:

Recall that “Working Capital” accounts≡ All Current BS accounts, not associated with financing or investment + any Non-Current BS accounts associated with day-to-day business.

Consider the Working Capital portions of SmallCo's 20X0 and 20X1 Balance Sheets, theassociated ΔWorking Capital, and the associated Sources and Uses:

From this we see that the tally of SmallCo's Sources and Uses is indeed equal to -ΔWorkingCapital (except ΔCash) for the firm.

Using -ΔWorking Capital (except ΔCash), we can re-write our definition of Operating CashFlow as:

Operating Cash Flow ≡

NI for period (ΔNI)

+/-ΔBalance Sheet amounts needed to convertfrom ΔNI to Cash Income

-ΔWorking Capital (except ΔCash)

This form used in many finance applications (as opposed to pure accounting situations).

HOW TO CREATE A PURE, INDIRECT METHOD

CASH FLOW STATEMENT, CONTINUED


II. Investing and Financing SectionsCreating the Investing and Financing sections of a Pure, Indirect Cash Flow is a straightforwardprocess. Here are the steps:

A) Work from the Transaction Table used to create Cash Flow from Operations.

B) Scan all the remaining “Other Δ Equity” and “ΔLiabilities - Other ΔAssets.”Categorize each entry as Investing or Financing, and identify it as a Source or a Use.

C) Put the resulting data into Pure, Indirect Cash Flow Statement format, along with theOperating portion of the statement.

INDIRECT CASH FLOW EXAMPLE 2:INVESTING AND FINANCING CASH FLOW FOR SMALLCO:

To find the Investing and Financing portions of SmallCo's Indirect Cash Flow statement wefollow the steps outlined above:

A) Work from the Transaction Table used to create Cash Flow from Operations.

Here is SmallCo’s 20X1 Transaction Table with completed Operating Cash Flow tabulations:

The first two columns on the right hand side of the equal signs comprise SmallCo's OperatingCash Flow data (totaling $400).

B) Scan all the remaining items in the “Other Δ Equity” and “+ ΔLiabilities - OtherΔAssets” sections.Categorize each entry as Investing or Financing, and identify it as a Source or a Use.

Recall that Investing entries are generated by non-operating investments of a firm’s resourceswith 3rd parties. Examples include: ΔPPE, ΔLoans Receivable, ΔInvestment Portfolio


Financing entries are generated by non-operating flows for obtaining or returning cash from or toa firm’s stakeholders. (Stakeholders as always include shareholders and lenders). Exampleentries are: ΔLoans/Bonds Payable (principal only). Δ PIC, ΔDividends.

Here is SmallCo's Transaction Table with all remaining items in the “Other ΔEquity” and “+ΔLiabilities - Other ΔAssets” sections categorized as Investing or Financing and flagged asSources or Uses:

Investing items are shown in green; Financing items are displayed in red. Notice that all theremaining entries in these sections represent Investing or Financing flows. Any remainingOperating items would indicate a mistake in our prior work.

C) Put the resulting data into Pure, Indirect Cash Flow Statement format, along with theOperating portion of the statement.

Here is Smallco's completed Pure, Indirect Cash Flow statement:


For comparison, here is the company's complete Direct Method Statement:

Note that the Total Cash Flow numbers on each statement are equal, as are the total OperatingCash Flow amounts. By contrast, the individual Investing and Financing subtotals do not match,but Investing + Financing subtotal matches.

Notice also that the Indirect Method Statement includes some non-cash Sources and Uses. Theseappear in all three sections of the statement.

THE GAAP-SANCTIONED INDIRECT CASH FLOW

STATEMENTGAAP and “Pure” Indirect Cash Flow Statements are the same except for two things:

1. GAAP renames the items used to compute Cash-Associated Income from ΔNI.2. GAAP uses the Direct-Method for its Investing and Financing sections.

To see how GAAP statements rename some items, consider the Operating portion of SmallCo'sPure Cash Flow Statement, and its Income Statement for the same period (20X1):

GAAP replaces the names of the entries we used to compute Cash-Associated Income with thenames of their “other side” entries, as they appear on the Income Statement. So for example,GAAP statements rename “Accumulated Depreciation” with “Depreciation”.

After renaming the components of Cash-Associated Income, the Operating portion of SmallCo'sGAAP-style, Indirect Cash Flow Statement looks like this:


Note that the numerical results of the GAAP and Pure Statements are identical, line-by-line.

The second (and final) change that GAAP makes to a Pure Statement is, as noted above, is theuse of Direct Method Investing and Financing Sections. Incorporating these modifications andthe above renaming changes into the Pure Statement gives us the completed GAAP-SanctionedIndirect Cash Flow Statement:

Going forward, we will use the GAAP-sanctioned version of the Indirect Statement.

SUMMARY:HOW TO CREATE GAAP-METHOD INDIRECT CASHFLOW STATEMENTHere are the steps needed to create a GAAP-Basis, Indirect Cash Flow Statement:

1. Assemble a Transaction Table for the period.

2. Create a Direct Method Cash Flow Statement and Income Statement (IS).

3. Compute Cash-Associated Income from the Income Statement. Start with Net Income andback-out the effect of all non-cash Income Statement items.

4. Identify all changes to Working Capital Accounts in the Transaction Table or journalentries. Flag each change a Source or a Use. Assemble the Sources and Uses into the“Working Capital Sources/(Uses)” portion of Cash Flow Statement.


5. Organize your results in Indirect Cash Flow Statement format {IE: Operating Cash Flow =Cash-Associated Income +/- Working Capital Sources/(Uses)}. Check that your total CashFlow from Operations is same as the total shown on your Direct Method Statement.

6. Add the Investing and Financing sections from your Direct Method Cash Flow Statement.

Here is a real-world-like example following these steps:

INDIRECT CASH FLOW EXAMPLE 3:GAAP-BASIS INDIRECT CASH FLOW STATEMENT FOR APO:Given following for APO during the year 20X1:

Economic events and journal entries for the year1

Corresponding Income and Direct Method Cash Flow Statements

Compute an Indirect-Method Cash Flow Statement for the year. Check your Cash Flow fromOperations against the Direct Method Statement.

Economic events for 20X1:

1. APO purchased inventory (homes) costing $34,000 on account.

(IE: was invoiced at time of purchase).2. Sold/invoiced $37,000 of homes to customers (APO ‘matches’ certain expenses to revenue

at the end of each accounting period, rather than with each sale).3. Received $1,000 in cash prepayment for services it promises to deliver in 20X2.4. Noted that its Cost of Goods Sold was $30,000.5. Received $33,000 in payments on previously-submitted invoices.6. Paid $29,000 of outstanding vendor invoices.7. Noted need to pay and paid $5,000 to rent office space for the year and for other

administrative costs.8. Prepaid $3,000 for 20X2 office space rent.9. Noted depreciation on all its PPE assets.10. Noted and paid 20X1 interest on its Loan Payable.11. Noted $1,000 of inventory was destroyed and useless as inventory but retained 500 in

salvage value.12. NA.13. Sold all its ‘Equipment Held for Sale’ for $700 cash.14. Estimated (noted) its 20X1 taxes at $147.15. Paid its owners a dividend of $100.

Transaction Table for the above events:

1 These are the same as given in Chapter 6 except that the buyout of BabyRealty is omitted. (IE: Event 12 isomitted).


20X1 Income Statement:

20X1 Direct-Method Cash Flow Statement:


Solution:Since we are given a Transaction Table, Income Statement and Direct Method Cash Flowstatement, we can begin with the third step in our Statement-Making methodology:

3. Compute Cash-Associated Income from the Income Statement. Start with Net Income andback-out the effect of all non-cash Income Statement items.

Here is APO's Income Statement, with non-cash items highlighted in yellow:

From this we get Cash-Associated Income:

Net Income (NI) $273+ Depreciation (Accum. Depreciation) $500+ Loss on sale (Equip held for sale) $300= Cash-Associated Income $1,073

The events that have been moved from their original Transaction Table locations are given inparenthesis for our information. (These will be omitted from the finished GAAP-methodstatement). Their corresponding Income-Statement names are shown first, per GAAPconvention. Note that, in each case, the amount to be moved is numerically equal to the amountshown on the Income Statement. Because this is always true, we do not have to search throughthe Transaction Table to find the correct amounts.

4. Identify all changes to Working Capital Accounts in the Transaction Table entries. Flageach change as a Source or a Use. Assemble the Sources and Uses into the “Working CapitalSources/(Uses)” portion of Cash Flow Statement.

Here is the Transaction Table with changes to Working Capital accounts highlighted in red:


Note that the above change in “Misc Asset” of $500 is a Working Capital Use, because the assetcame out of Inventory, as seen in the list of economic events or the original Transaction Table.Inventory Write-Downs are considered part of industrial companies normal business operations.

Similarly, the change in “Equipment Held for Sale” of ($1,000) is not a Working Capital source,because the asset came out of “Property, Plant and Equipment” (by definition), which isassociated with Investing cash flows.

Here is APO's list of “Working Capital Sources and Uses,” ready for placement into its DirectCash Flow Statement:

Working Capital Sources/(Uses):

AR -$4,000 (Uses)Inventory -$3,000Misc. Assets -$500Prepaid Rent -$3,000AP -$5,000 (Sources)Accrued Tax $147Unearned Revenue $1,000Total -$4,353

5. Organize your results in Indirect Cash Flow Statement format {IE: Operating Cash Flow =Cash-Associated Income +/- Working Capital Sources/(Uses)}. Check that your total Cash Flowfrom Operations is same as the total shown on your Direct Method Statement.


Here is the complete Operating portion of APO's Indirect Cash Flow Statement:

Cash Flow From Operations:

Net Income (NI) $273

+ Depreciation (Accum. Depreciation) $500+ Loss on sale (Equip held for sale) $300= Cash-Associated Income $1,073

+/- Working Capital Sources/(Uses):

AR -$4,000Inventory -$3,000Misc. Assets -$500Prepaid Rent -$3,000AP $5,000Accrued Tax $147Unearned Revenue $1,000Cash From Operations -$3,280

Note that the total Cash From Operations is the same as the Direct Method total shown above.

6. Add the Investing and Financing sections from your Direct Method Cash Flow Statement.Put the entire result into Indirect Cash Flow Statement format.We take the Investing and Financing Sections from the Direct Method Statement given above.With these, we assemble APO's complete, GAAP-basis Indirect Statement:

As shown, Indirect Cash Flow Statement format includes presentation of the firm's EOP andBOP cash balances. The BOP cash balance would normally be taken from the entity's BOP


Balance Sheet, which is unavailable for this example. The EOP cash balance would normallybe computed from the BOP balance and the total cash flow, then checked against the firm's EOPBalance Sheet.

For comparison purposes, here again is APO's Direct Method Cash Flow Statement for 20X1.The Total Cash Flow and subtotals for Operating, Investing and Financing all match the IndirectStatement numbers, as they must.


FINANCIAL STATEMENT ANALYSIS

PART I:INFORMATION AND INSIGHTS DERIVED

FROM FINANCIAL STATEMENTS

CHAPTER 13

CHAPTER13–FINANCIALSTATEMENTANALYSIS:PARTI PAGE1Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

INTRODUCTION TOFINANCIAL STATEMENT ANALYSIS

Now that we have learned so much about accounting techniques and statements, lets use thisknowledge to analyze companies. As we have glimpsed already, accounting information helpsus answer important financial questions, such as:

§ Should we make an equity investment in this company?

§ Should we make the company a loan?

§ Is the company better off than its comparables (“comps”)?In this chapter we will use our accounting expertise to develop a framework for answering theseand other questions.

A reasonable company-analysis starting point may seem to be the inspection and review of anentity's individual financial statements. Although this technique is helpful, its utility is limited.By simply reviewing individual statements we have difficulty assessing trends, such as theperformance of a company's Net Income relative to its revenue over time. Also, we arecompletely unable to gauge the company's performance relative to its comps or to macro-economic conditions.

Ideally, we'd like to formulate analysis methods that help us understand a company's financialstate relative to its history and its comps, as well as to industry-specific and macro-economicconditions. In this Chapter we will consider two financial-statement-based tools that are wellsuited to these purposes: Common-Size Financial Statements and Ratio Analysis.

ASSESSING ENTITIES' FINANCIAL PERFORMANCE

THROUGH THE GREAT RECESSIONIts interesting to look at companies' financial performance during the Great Recession (roughlyDec 2007 through June 2009), to see how well they handled this extreme economic downdraft.The performance of airlines during the recession is particularly intriguing: Many “legacy” (old)airlines entered the recession in a weak state, and were hammered by decreased demand andunexpected, increasing fuel prices. Most of these entities ended up in bankruptcy court, butseveral of them, such as Continental Airlines1, surprisingly lived to fight another day. Bycontrast, some relatively new, “low cost” airlines – including Southwest and Alaska Air – enteredthe recession in a strong financial position and were relatively unaffected by it. In this chapterwe use Common-Size Financial Statements and Ratio Analysis to compare and contrastContinental’s and Southwest's financial journey through the Great Recession.

1 Continental is now merged with United and carries the United name.


COMMON-SIZE FINANCIAL STATEMENTS

The basic idea behind Common-Size Financial Statements is to show Income Statements,Balance Sheets, etc. with all quantities normalized to a key item. For example, a Common-SizeIncome Statement shows each quantity as a percent of sales in the period. (So here, sales is thekey normalizing item). By comparing Common-Size Income Statements for several periods, wecan quickly determine if costs are rising relative to sales, or if profit (Net Income) is increasingin proportion to sales.

Similarly, Common-Size Balance Sheets show all items on a company's Balance Sheet as apercent of its total assets. Again looking at statements from several adjacent periods, we canquickly determine, for example, if a company's debt is increasing relative to its assets (increasingthe entity's financial risk), or whether its equity base is shrinking.

COMMON-SIZE STATEMENTS EXAMPLE:CONTINENTAL AIRLINES (CAL) DURING THE GREAT RECESSION

Lets create and scrutinize Continental's (CAL's) Common-Size Income Statements for part of theGreat Recession. First, here is a bit of background:

At the onset of the period, CAL was typical of the legacy airlines. It shared with its peers: A high fixed cost structure, due in part to its great variety of old planes with inefficient

engines, and its unsustainable union contracts. Lots of debt relative to its ability to repay it and relative to its equity. Difficulty competing with new, low-cost rivals, such as Southwest, Alaska Air and JetBlue. A struggle to cope with the skyrocketing cost of jet fuel2, which was caused by stagnant

global supply and escalating demand in developing countries.

2 Demand was especially growing in China, where it was increasing by about 8% per year at the start of therecession. As a result of this supply/demand imbalance, the price of jet fuel increased from $1.65 per gallon inJanuary 2007 to $3.89 per gallon in July of 2008. The price subsequently declined as the worldwide recessionreduced global demand.http://www.indexmundi.com/commodities/?commodity=jet-fuel&months=120.

“Causes and Consequences of the Oil Shock of 2007-08.” James Hamilton.http://dss.ucsd.edu/~jhamilto/Hamilton_oil_shock_08.pdf


Here are CAL's Income Statements for the six quarters ending 6/30/2008:

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To make these Common-Size Statements, we divide each entry of each quarter's Income Statement by the sales (Revenue) of the quarter. Forexample, SGA for the quarter ending 12/31/2007 will be:

Cost of Goods Sold (COGS) / Revenue = 3102 /3523.0 = 88.0%

Performing this division for each item in each quarter yields six Common-Size Statements for CAL:

Before we start analyzing the Common-Size statements, we need to decide how to compare quantities across time periods. In particular, should we

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compare quarter by quarter (quarter ending 3/31/2008 to quarter ending 12/31/2007) or year overyear (quarter ending 3/31/2008 to quarter ending 3/31/2007)?

The answer depends on whether or not CAL is a “seasonal” company. Seasonal entitiesexperience peaks and troughs in revenues and/or costs during various times of the year. Non-seasonal companies generally experience steady sales and costs throughout the year. Retailbanks are good examples of non-seasonal companies.

Like most airlines, CAL experiences its biggest sales at particular times of the year, such as thesummer vacation season, when many consumers travel. So we can safely conclude that CAL isseasonal and we should compare its numbers for each quarter to their year-ago counterparts.

Don't worry if this was not obvious to you – you can always look it up. Publicly-tradedcompanies like CAL report their seasonality (or lack thereof) in annual filings to the Securitiesand Exchange Commission (SEC) called 10-K reports. CAL's filing from 2008, for example,states:

Due to greater demand for air travel during the summer months, our revenue in the secondand third quarters of the year is generally stronger than revenue in the first and fourthquarters of the year. Our results of operations generally reflect this seasonality,…

You could also try to determine if CAL is seasonal by plotting its quarterly revenue. Thistechnique works for steady-state companies in steady-state economic conditions. It does notwork well for volatile companies during volatile economic periods, because seasonality inrevenues may be masked by sales swings from other causes.

Having established CAL's seasonality, we are ready to analyze its performance via its Common-Size Income Statements. The best place to start reviewing Income Statements is usually withRevenue and Revenue growth. This is because Revenue is the cardinal measure of the scale of afirm, and because many changes in companies' performance are down to changes in sales.

For studying Revenue and Revenue growth, CAL's raw Income Statements are actually morehelpful than its Common-Size equivalents, because all the Common-Size sales numbers read100%. So lets put this research aside for now, and look at the second best place to startreviewing an Income Statement: Net Income. Net Income is good to look at because, as weknow, it shows what a company earns from day-to-day operations, after also making requiredpayments like interest, taxes, etc.

A quick glance shows us that CAL's Net Income is collapsing. It declined from 0.7% of sales inthe quarter ending 3/31/2007 to -3.5% in the quarter ending 3/31/2008. Worse, CAL's NetIncome swung from 6.3% of sales in the 6/30/2007 period to -1.1% in the period ending 6/302008.

Our next step is to suss-out why CAL's Net Income is dropping. For this we scan other IncomeStatement items for big changes. We see that CAL's Cost of Goods Sold (COGS) has increasedover the same periods that its Net Income has declined from 81.6% to 85.5% and 75.8% to


84.1% respectively. A careful review of all the Income Statement items confirms that these arethe biggest increases in CAL's expenses by far.

CAL's COGS-to-sales increases resulted from either its revenues decreasing relative to COGS, orits COGS increasing relative to sales. By looking at CAL's raw Income Statements, we see thatsales have been growing (year over year) by about 9% to12%. From this we infer that theproblem is not caused by a sales decline. Instead CAL's COGS Expense has been increasingfaster than its revenues.

The reason for CAL's COGS increase in this period is the skyrocketing price of jet fuel. Forairlines, fuel is part of COGs Expense. In the period we are reviewing, the jump in jet fuelprices has driven up CAL's COGS expense so much that it caused the firm's Net Income to swingfrom positive to negative.

Good to Know:In financial statement analysis, and throughout finance generally, the changes that matter areusually big, and small changes may often be ignored. This is because there are many variablescontributing to financial performance, and most of them are somewhat unpredictable. As aresult, we can often focus on big changes to the exclusion of other “noise.” This is in contrast tosome other fields of study, like many engineering disciplines, where small changes are importantand numbers must be monitored to many significant figures.

We could perform a similar analysis of CAL's Balance Sheets by preparing Common-SizeBalance Sheets. This would yield several decent insights, but I think our time will be betterspent by moving on to a more useful technique.

LIMITS OF THE COMMON-SIZE STATEMENT

METHODOne problem with the Common-Size Statement method is that it includes a lot of unhelpfulinformation. CAL's Common-Size Income Statements, for example, show both COGS andGross Profit ( = Revenue - COGS). Both of these items give us the same insights, packaged inslightly different ways. Ideally, we'd like to work with a method that provides just the numberswe need, instead of the shotgun approach provided by the Common-Size method.

Another problem with the Common-Size method is that it restricts us to considering only ratiosfrom one type of financial statement at a time, with only one constant value (Revenue or totalAssets) in the denominator of each ratio. It would be more helpful to use any appropriatenumber in the denominator of our ratios, and to compare numbers from more than one financialstatement at a time.


RATIO ANALYSIS

Ratio Analysis overcomes both of these issues. Its basic philosophy is to consider ratios thatmay provide important insights, irrespective of the individual items and financial statements thatthey are assembled from. Here is a quick example. Consider the Asset Efficiency Ratio:

Asset Efficiency≡ RevenueRatio Total Assets(BOP)

This ratio employs quantities from two different financial statements (the Income Statement andthe Balance Sheet) and two different accounting periods. It measures how many dollars of salesan entity generates in a period from the assets it held at the beginning of the period. This isclearly a useful metric for evaluating industrial entities, which provides insights unavailable fromCommon-Size Statements.

Ratio Analysis is often used to simultaneously analyze a company's performance relative to itshistory and to one of more comparable companies (one or more “comps”). When comparing tocomps, it's important to include only truly-comparable companies, not simply competitors. Thisis because some competitors may not be directly comparable. For example, two of the world'slargest aircraft leasing companies are International Lease Finance and GE Capital. InternationalLease Finance (ILF) is 100% devoted to the business of leasing aircraft. GE Capital, by contrast,operates in the Consumer Finance, Energy Services and Real Estate businesses, in addition toAircraft Leasing. This “pollutes” GE Capital's financial date with date from three businessesunrelated to aircraft leasing. Its financial statements are therefore not comparable. to ILF's, and itis not considered to be one of ILF's comps.

ILF and GE Capital can be properly compared by extracting GE Capital's aircraft leasing datafrom its overall financial statements. GE Capital provides this breakout on some of its filingswith the SEC, such as its annual, 10K reports.

Other issues that may keep competing companies from being comps are large differences in size,or little overlap in geographic or demographic market segments. In the real world, finding truecomps is sometimes virtually impossible; in these cases its usually worth comparing competitorsthat are as comparable as possible.

EXAMPLE: COMPARABILITY OF CONTINENTALAND SOUTHWEST AIRLINES

Lets check the comparability of Continental (CAL) and Southwest (LUV). CAL's key features(as of 2008) are: Being a full service airline, offering first-class, business-class and economy seats. Annual sales of about $15BB. Operating in the U.S. and international markets.


“Hub and spoke” logistics, with primary hubs in Newark NJ, Houston TX, and ClevelandOH.

LUV's primary characteristics (again as of 2008) include: Being a low cost airline, offering only economy class and no reserved seats. Annual revenue of about $10BB Operating only in the U.S. “Point to point” logistics, with no hubs.

By comparing each company's characteristics, we see that CAL and LUV are not perfectlycomparable. Their market positioning (full service vs low cost) and geographic domains are notan exact match, and their logistical strategies are opposite. Nonetheless, they are both American-flagged carriers devoted solely to moving passengers and cargo by air. Also, their annual salesare the same order of magnitude, and big enough to make them significant players in the U.S.airline industry. So on balance, we will conclude that a comparative Ratio Analysis will beuseful.


CLASSES OF RATIOSThere are five important classes of ratios:

1. Revenue and Revenue Growth Ratios.2. Margin Ratios.3. Turnover (Efficiency) Ratios.4. Financial and Operating Leverage Ratios.5. Liquidity Ratios.

Lets look at them all, starting with Revenue and Revenue Growth Ratios.

REVENUE AND REVENUE GROWTH RATIOSThere are at least two good reasons to consider a company through the prism of its sales andsales growth. First, sales is the cardinal measure of the size or scale of a firm. Annual revenue isalmost always the answer to the question, “how big is the firm?” This is true notwithstanding theobsession with “market capitalization” (stock share price times number of shares outstanding)seen on the worst of the financial news networks.3 Second, many changes in a company'sperformance over time are simply due to its sales growth or decline.

For seasonal companies like CAL, revenue growth in the most recently-reported period ismeasured as follows:

Quarterly Growth: (RevenueQ5 – RevenueQ1) / RevenueQ5

Annual Growth: (RevenueY2 – RevenueY1) / RevenueY2

Where Q1 is CAL's most recently reported quarter, Q5 is the year-ago quarter, Y1 is CAL'smost recently reported year, and Y2 is the prior year.

For non-seasonal companies, annual revenue growth is measured as above, and quarterly growthis measured as:

Quarterly Growth: (RevenueQ2 – RevenueQ1) / RevenueQ2

Where we compare the sales of sequential quarters.

REVENUE RATIOS EXAMPLE:CONTINENTAL AND SOUTHWEST

Consider this Revenue and Revenue Growth information for CAL and LUV4:

3 It is also fair for some purposes to measure the size of a firm with a Balance Sheet metric. Even in these cases,measuring size by market capitalization is useless. This is because two comparable firms in the same industrymay have the same annual sales and total assets, but wildly different market capitalizations. The two firms arenonetheless the same size by any reasonable measure. The companies' differing market caps stem from differentchoices related to raising capital with debt vs equity. (The details of these differences are beyond the scope ofthis book, but are explained in any good Corporate Finance text).


To read the table, note that:

Q1 is the quarter ending 6/30/2008. Q2 is the prior quarter (ending 3/31/2008), Q3 is the quarter prior to Q2, etc. TTM stands for “Twelve Trailing Months.” In this case, where the date is measured

quarterly, this translates into four quarters worth of data(IE: TTM = Q1 + Q2 + Q3 + Q4).

Each data item is represented in two rows. The first row shows data for CAL, and thesecond row, labeled “Comps” holds data for LUV.5

Sales Growth for these seasonal companies is measured year over year.(IE: CAL's Q4 Sales Growth of 8.58% = ($3,820 - $3,518) / $3,518).

The table provides us with some good insights, such as: As noted previously, the annual sales of the companies have the same order of magnitude,

helping to affirm their comparability. Both companies are growing sales nicely on a TTM basis. On a quarterly basis, they are

both also growing sales, but with more volatility. This information give us a heads up thatother problems we may find, like poor profitability, will not be caused by revenue declines.

We saw above how quarterly Sales Growth is computed for these and other seasonal companies.Now lets calculate CAL’s Q1, TTM Sales Growth:

TTM Sales Growth of 10.3% = {14,957 – (3,518 + 3,156 + 3,179 + 3,710)}(3,518 + 3,156 + 3,179 + 3,710)

MARGIN RATIOSOur second class of ratios is Margin Ratios, which measure an Income Statement (IS) or CashFlow Statement (CFS) quantity relative to another quantity drawn from either of thesestatements. Mathematically, we define Margin Ratios as:

Margin Ratio ≡ IS or CFS term Another IS or CFS term

4 All of CAL's financial statements used to prepare this table and the remaining ratio tables in this chapter arelocated in the chapter's appendix.

5 The Ratio Analysis data in this chapter is compiled from a proprietary database/spreadsheet package. In thissoftware, “Comps” information may be sourced from a single company such as LUV, or an amalgam of manycomparable companies. This feature allows users to benchmark a company to a single comp, or to a collectionof comps that represent the average performance of an entire industry.


Almost always, the denominator of a Margin Ratio is Revenue for a period or periods.

Net Income MarginThe most common Margin Ratio is the Net Income Margin (NI Margin) or Profit Margin, definedas:

NI Margin ≡ Net Income Revenue

It represents the amount of Net Income that a company yields from its sales, usually expressed asa percent. It may be measured over any accounting period, as long as the period for NI is thesame as for Revenue. Bigger is better for this ratio, as the more NI a company can extract fromits sales, the better.

The NI Margin is directly useful to potential investors. When comparing two companies, a debtor equity investor may choose, all else being equal, to invest in the entity with the highest NIMargin.

Most company managers and executives are interested in how they can increase their ProfitMargin. We can see how to improve the ratio by simply considering the effect of its numeratorand the denominator. Clearly, a Profit Margin will be improved when an entity's Net Income isincreased, or when its Revenue is decreased. Unfortunately, Net Income and Revenue are notindependent (NI = Revenue – Expenses), making it difficult to decrease sales without alsodecreasing NI, and vise-versa.

An operational approach to increasing Profit Margins is to decrease expenses without decreasingsales. This will augment Net Income and increase the Profit Margin Ratio. For example, CALcould replace its old, inefficient jet engines with new efficient models. This would lower its fuelexpense without having any impact on its sales.

A strategic approach to increasing Profit Margins is to decrease sales of poorly-performing or“low margin” businesses. In this way, Revenue reduced more than Net Income, which producesa net increase in the Profit Margin.

EXAMPLE:STRATEGICALLY CUTTING SALES TO IMPROVE PROFIT MARGINS

(WITH AN INTRODUCTION TO INVESTMENT BANKING)Imagine that you are the proud owner/operator of , a small-time grower and distributor of high-quality apples. While hanging out at the Uncommon Grounds coffee shop you are accosted byyour local investment banker, who shows you how to improve your business with thispresentation:

First, he reminds you of your farm's recent overall performance:


Vermont Organic Apples Q4 20X0Income Statement ($K UON)Revenue 20GOGS 14Other Expenses 1NI 5

NI Margin 5/20 = 25%

Then he breaks out the farm's performance by your two product lines (apples sold as-is, andapple butter), and shows you what it would look like without the apple butter business.

IS Apples + A. Butter = Total OnlyItem Business Business ($K) A. Butter

Revenue 10 10 20 10GOGS 5 9 14 5Other Exp.* NA NA 1 1NI 5 4NI Margin 25% 40%

* Office, accountant, etc.

He points out several things:

As you can see from above statement Although your apple butter business has the same revenue as your apples as-is business,

it carries almost twice as much COGS expense. You could almost double your profit margin – moving it from 25% to 40% – by simply

dropping your low margin, apple butter business. The apple butter business is high risk. If, for example, a batch is made improperly, it could

grow the Botulinum toxin and give your customers botulism. This would cause pain,sadness and death in your community, as well as the bankruptcy of your farm.

As a farmer, you would be better off “sticking to your knitting” by concentrating on growingand selling farm products, and leaving the processing of foods to food processing experts.

For an only-nominally-outrageous fee, he and his firm would be happy help you sell therisky, under-performing apple butter business, and find ready markets for your new surplusof apples.

The banker has properly pointed out how you can improve your profitability (as measured by theprofit margin) by reducing the sales of your worst-performing business. However, like anychange in strategy, his plan brings its own risks. One danger, for example, is that you are unableto find a market for the new as-is apples that used to go into your apple butter. The banker mayneglect to tell you about this and other risks, because he is incented to make you accept hisadvice.


Imagine now that you take the banker's advice. In this case, the banker may wait five years tocontact you again, then approach you with a new strategic pitch:

Your current business is awfully risky, inasmuch as it relies on just one product (as-isapples). Also, all your revenue from the apples is realized over one or two months per year,after you have already invested much time and money in the crop. One premature ice stormcould ruin most of your harvest, resulting in a big loss for the year.

Your business would clearly benefit by diversifying its product base and by generating salesthroughout the year. Diversifying would reduce potential act-of-nature damage, and salesmade during the spring and summer would help meet the costs of maintaining your orchardsand tending your apple trees.

He knows just the thing to get you diversified and to spread your revenue throughout theyear – an apple butter business!

He also just happens to know of a small apple-butter business that your could purchase at areasonable price, plus an only-nominally-outrageous commission for the banker himself.

Its a sad truth about investment banking that bankers are generally incented to earn fees andcommissions by “doing deals,” whether or not the deal is in the best interest of their clients. Agood, nuanced, real-world example is the case of Dragon Systems' sale to Lernout & Hauspie in2000. Reporting on the case is available here: "Goldman Sachs and the $580 Million BlackHole" and at many other places via Google or Bing searches.

COGS MarginLets continue working our way through the most common Margin Ratios, starting with theCOGS Margin, and its cousin the Gross Margin Ratio. The two ratios are defined as follows:

COGS Margin ≡ COGS / SalesGross Margin ≡ (Sales - COGS) / Sales

Both ratios only apply to industrial entities, and are usually expressed as percentages. Iemphasize the COGS Margin, because of its simplicity, directness, and consistency with othercommon Margin Ratios. Note that:

COGS Margin + Gross Margin = 100%

The COGS Margin measures how much of an entity's sales are eaten up by the cost of itsinventory. In this case, smaller is better. By looking at the ratio for several consecutive periods,it also tells us if an entity's purchasing and plant-operations are getting more or less efficient.Similarly, by comparing the COGS Margin to one or more comps, it shows us how efficient anentity is relative to an individual competitor or its industry. Finally, the COGS Margin estimatesan entity's variable costs. Variable costs are those that scale quickly in proportion to sales.COGS is a good measure of variable costs because the more an industrial entity sells, the moreinventory it needs and the more COGS Expense it generates.


SGA MarginThe SGA Margin (Selling, General and Administrative Expense Margin) is defined as:

SGA Margin ≡ SGA / Sales (Expressed as %)

SGA Margin measures how much of an entity's Revenue is eaten up by its SGA Expenses. Likethe COGS Margin, smaller is better. If we review the ratio over time or in comparison to compswe find, respectively:

If selling and administrative costs are increasing or decreasing, relative to the growth of thefirm overall.

How an entity's selling and admin costs stack up next to a comparable or to its industry'saverage.

The ratio also provides a reasonable guesstimate of a firm's fixed costs relative to its sales. Fixedcosts, unlike variable costs, don't scale quickly in proportion to sales. An example is costs for acompany's HR department, accounting department, and executive suite. If the firm's sales slow,it would be hard fire significant segments of these departments, because their functions wouldremain undiminished (over the short term) despite a drop in revenue. Likewise, a well run firmshould not have to expand these departments in lockstep with sales increases.

This said, the SGA Margin is not a perfect measure of fixed costs, for two reasons. First, itincludes some variable costs, such as advertising. If sales drop, its quick and easy to cut back onthis expense. Second, some important fixed costs are not included in SGA, such as for exampleInterest Expense. Interest cost is a function of how much debt a firm has outstanding and therate it pays on this borrowed cash. Debt levels are typically set for longish periods and are notadjusted quickly to a company's sales.

The imperfectness of SGA Margin as a measure of fixed costs is typical of many ratios. Ingeneral, ratios are not flawless measuring tools, and they often work better in some industriesthan others. Also, as we saw with the COGS Margin Ratio, some ratios are only applicable tocertain types of entities – Industrial, Service or Financial.

Interest MarginThe Interest Margin Ratio is established as:

Interest Margin ≡ Interest Expense / Revenue (Expressed as %)

As with any Margin Ratio with an expense in the numerator and sales in the denominator,smaller is better.

The Interest Margin tells us how much of our sales we have to pay as debt service to our lenders.This ratio is a rough measure of a firm's riskiness, with increasing Interest Margin equating tohigher risk. It works like this: the more interest a firm must pay the less cash it has to meet othernecessary expenditures.


As usual, viewing this ratio over time or in comparison to comps provides some good insights.By looking over time we can see if an entity is getting riskier. By comparing to one or morecomps, we can benchmark an entity's riskiness relative to a competitor or to its industry average.

Effective Tax RateAn entity's is Effective Tax Rate is computed as:

Effective Tax Rate ≡Tax Expense/Earnings Before Tax (Expressed as %) = Tax Expense / EBT

This is one of the few Margin Ratios that does not feature Revenue in the Denominator. TaxExpense typically includes income taxes and short term capital gains taxes, but not real estatetaxes and fees. The ratio does not apply to Limited Liability Companies (LLCs), Real EstateInvestment Trusts (REITs) and other entities that do not pay income tax.

Smaller is generally better (unless you are wildly patriotic). The ratio tells us how much of afirm's pre-tax income goes to the government. By looking over over time and in comparison toother companies, this ratio may be used to benchmark an entity's tax efficiency against itshistory, a single competitor, or its industry average.

MARGIN RATIOS EXAMPLE – CONTINENTAL VS SOUTHWEST AIRLINES

Consider the following Margin Ratio data for CAL and LUV6. Lets use this info to ask andanswer some interesting questions about the competitors.

Questions:1. During last year:

Who had better profitability on average? Why? Who was more consistently profitable?

2. What can you say about COGS trend for each company? Why?

6 Reminder: All of CAL's financial statements used to prepare this table and the remaining ratio tables in thischapter are located in the chapter's appendix.


Solutions:1. “During the last year” suggests that we should be looking at Q1 through Q4 ratios.

“On Average” implies that we should be looking at TTM figures.

Profitability is measured by the Profit Margin Ratio. Comparing the TTM numbers for CALand LUV we see that LUV is far more profitable on average, with a TTM profit margin of6.00% vs CAL's measly 0.84%.

Looking quarter by quarter, we see that LUV was also more consistently profitable. Thoughboth firm's profits were volatile (partly because of their seasonality), CAL's profit marginwas negative for three of the four latest quarters, while LUV was always profitable.

2. For COGS trends, we should review all eight available quarters, looking year-over-year.CAL's COGS Ratio held steady for Q8 to Q4 and Q7 to Q3, but started to jump up in Q6 toQ2 and Q5 to Q1 (79.1% to 83.8%, and 75.8% to 83.7% respectively).LUV's COGS ratio has started to increase over the same period, rising from 74.7% in Q6 to75.3% in Q2, and from 67.9% in Q5 to 73.9% in Q1.

In both cases, the increase is largely due to spiking jet fuel prices.

TURNOVER AND EFFICIENCY RATIOSOur third class of financial statement ratios is comprised of Turnover and Efficiency Ratios.Turnover Ratios are defined as:

Turnover Ratio ≡ (A Balance Sheet Term)

(An Income Statement or Cash Flow Statement Term)

Efficiency Ratios are similar, but with the numerators and denominators switched:

Efficiency Ratio ≡ (An Income Statement or Cash Flow Statement Term)

(A Balance Sheet Term)

Turnover Ratios measure things like how much sales or earnings a firm's assets generate.Efficiency Ratios tell us, for example, how quickly an entity converts assets into sales or cashflow, and related metrics. Lets look at some of the most common Turnover and EfficiencyRatios.

Asset Efficiency RatioWe looked briefly at the Asset Efficiency Ratio earlier in this chapter. Recall that it is computedas:

Asset ≡ Sales (AER, typically expressed as %)Efficiency Assets(BOP)

As we noted previously, the Asset Efficiency Ratio measures the amount of sales companygenerates from each dollar of its assets, during an accounting period or periods. It is most


applicable to industrial entities, which may use large amounts of PPE and other assets to createinventory. Like virtually all ratios, it is helpful for benchmarking an entity relative to its history(by looking at the entity's ratio over multiple periods), and to its industry or to a single comp (bycomparing the entity's ratios with the comps').

Bigger is usually better for this ratio, but not always. In general, entities should try to sell asmuch as possible utilizing as few resources as possible. However this can go too far. ConsiderVermont Organic Apples again. Say the owner notices that of his two tractors, only one isneeded about 90% of the time. He figures that, by working his first tractor a bit harder, he cansell the second one – and enjoy a one-time, sale-price cash flow as well as ongoing savings inmaintenance and repair costs. The fatal flaw with this analysis is that, if the owner's singletractor fails during the apple harvest season, he may loose much of his crop because he can'ttransport it. The lesson is that entities should be as “lean” as possible without significantlyjeopardizing their ability to operate.

Almost every time we say that “bigger is better” or “smaller is better” for a given ratio, thisclaim needs to be qualified and not taken to extremes. Going forward I'll assume we allunderstand this, and will stop describing the particular qualifications for most individual ratios.

Unlike the case for Sales Growth Ratios and Margin Ratios, we have to be careful with the unitsof Turnover and Efficiency Ratios. Notice that Turnover Ratios carry units of(Dollars) / (Dollars per period), and the units for Efficiency Ratios are the inverse of this. Toensure that we make apples-to-apples comparisons of these ratios, we will usually choose units of(Dollars) / (Dollars per Year) or the inverse of this. So, for example, an annual Asset EfficiencyRatio will be computed like this:

Asset Efficiency Year 20X0 = (Sales) For the Year 20X0 / (Total Assets) BOP 20X0

with units (Dollars per year) / (Dollars). The ratio for the third quarter of the year will becomputed as:

Asset Efficiency Q3 = 4*(Sales) For Q3 / (Total Assets) BOP Q3

Multiplying the Q3 sales by four converts the units from Sales per year to Sales per quarter.After converting, we can directly compare the Year 20X0 ratio with the Q3 ratio, as they nowcarry the same units.

Return on AssetsReturn on Assets is defined as:

Return on Assets ≡ Net Income / Assets(bop) (ROA, expressed as %)

ROA is the income an entity produces for its owners during a period, using the assets it had towork with at the beginning of the period. Like Asset Efficiency, it is most useful for industrialcompanies, and bigger is often better.

An imperfection of ROA is that Net Income measures returns only to an entity's owners, but thefirm's assets have been funded by owners, lenders, and profitable business operations. For this


reason, some analysts, executives and managers prefer the ratio EBIT/Assets to AER. EBITstands for Earnings Before Interest and Tax, and it represents income available to lenders andowners.

Return on EquityReturn on Equity, or ROE is computed as:

Return on Equity ≡ Net Income / Equity(bop) (ROE, expressed as %)

ROE measures how much income an entity generates for its owners, relative to the firm's equityat the beginning of the period. Bigger is better. This ratio is useful for all types of entities –Industrial, Service and Financial – and is arguably the most common financial-statement ratioused by managers and equity investors.

Good to KnowMost analysts and managers are happiest when ROE is positive, large, and growing. This said,for big companies in most industries, an ROE between about 8% and 20% is pretty good. Thecap of 20% comes from competition. If smart businesses see a company earning an ROE of, say,50% or more, they will be temped to enter the business themselves. This added competition willtypically drive down prices (and therefore Revenue), and lower ROE for everyone.

Since bigger is better for ROE, it can be improved by increasing its numerator (Net Income) ordecreasing its denominator (equity). Increasing Net Income would typically be done through anoperational plan, such as by reducing costs without impairing sales. Decreasing equity istypically a long-term, financing-strategy decision. Equity can be reduced in a number of ways,including for example:

A leveraged buyout, which would exchange equity for debt. Using a firm's cash generated by operations to repurchase and retire some of its equity

shares.

We will learn more about the importance of equity to ROE later in this chapters, when we look atLeverage Ratios.

EXAMPLE: COMPUTING CAL'S ROELets take a minute out to be sure you understand how to compute ROE, and by extension, otherEfficiency and Turnover Ratios. Consider this information taken from CAL's financialstatements, as listed in Appendix to this chapter).

Balance Sheet


Income Statement

CAL's TTM (annual) ROE is computed as follows:

ROETTM: = NITTM / EquityBOP = 126 / 950 = 13.3%

Where EquityBOP measures equity at the beginning of the twelve month period, or at the end ofQ5. The units used are (Dollars per Year) / Dollars.

CAL's Q1 ROE is computed as:

ROEQ1: = 4* NIQ1 / EquityBOP = 4 * (-3 / 1,471) = -0.8%

Where EquityBOP measures equity at the beginning of Q1, or the end of Q2. The units used ofDollars per Quarter are multiplied by four to convert them to Dollars per Year units.

Fixed Asset Efficiency (FAE)The FAE Ratio is:

Fixed Asset Efficiency ≡ Revenue / Net PPE(bop) (FAE, expressed as %)

FAE Ratio measures how much Revenue (sales) a firm generates in a period from the net PPEavailable at the beginning of the period. It is useful for understanding heavy industrial entities,like car manufactures, that use a lot of PPE to create inventory. It is also a good ratio for firmsthat generate sales directly from their PPE, such as REITs (which generate Revenue by leasingthe space in their buildings) and utilities (that sell the electricity generated by their power plants).

FAE is usually described with “times,” percent, or no modifier. For example, an entity may say“our sales are 2.7 times our fixed assets,” “our sales are running at 270% of our fixed assets,” or“our FAE is 2.7”

Inventory Efficiency (Inv-E)This ratio measures how much inventory a firm matches to its sales in a period. 7 It is defined as:

Inventory Efficiency ≡ (COGS) / Inventory(bop) (Inv-E, expressed as %)

The ratio only applies to Industrial entities, and bigger is better.

Accounts Receivable Turnover (AR-T)AR-T is defined as:

Accounts Receivable Turnover ≡ Accounts Receivable (EOP) / (Sales made on credit)

7 Recall that COGS represents the amount of inventory sold in a period, as measured by the lower of cost ormarket.


This ratio aims to measure how much of a company's credit sales remain uncollected at the endof an accounting period.

In this case smaller is better. This is because of a general rule in finance: within reason, itsalways better to receive cash as soon as possible, and to delay dispensing cash for as long aspossible. So, at the end of an accounting period, firms ideally want to have received cash forevery sale made in the period.

Clearly, this ratio only applies to firms who make most of their sales on credit 8, as opposed tothose collecting cash at the time of sale. Unfortunately, most entities do not report how much oftheir sales are made on credit. For this reason, AR-T is often computed as:

AR-T ~ Accounts Receivable(EOP) / (Revenue) = AR (EOP) / (Revenue)

where “~” means “is approximately equal to,” as used throughout this text. The approximation isgood for firms that make most of their sales on credit.

AR-T is described using percent, years, or days, as follows:

“At EOQ-3, our Accounts Receivable is running at 27% of annualized sales.” “At EOQ-3, our AR-T is 0.27 years.” “At EOQ-3, our AR-T is 99 days.”

(Where we converted from “years” to “days” by multiplying by 365. 99 = 0.27*365).

Accounts Payable Turnover (AP-T)The Accounts Payable Turnover Ratio is really a liability Turnover Ratio. It is defined as:

Accounts Payable Turnover Ratio ≡ Accounts Payable(EOP) / Inventory Purchases in thePeriod.

This ratio is a corollary to the AR-T Ratio. It aims to measure how much of a company'sinventory purchases were paid for during a period. For the AP-T Ratio, bigger is better, becausea firm with a big ratio is making payments later (and holding onto cash longer) than a companywith a smaller ratio. This ratio is described using percent, years, or days.

Because inventory purchases are not reported directly by most companies, AR-T is oftenapproximated by:

AP-T ~ Accounts Payable(EOP) / COGS

COGS is often, but not always, a fairly decent proxy for inventory purchases. Here is how itworks:

Let “I” stand for Inventory. Then for a given accounting period:

IBOP + (Purchases of I) – COGS = IEOP, where we assume no write-downs.

Re-arranging terms, we get:

(Purchases of I) = COGS + ΔI

8 IE: firms that invoice most of their sales, or allow customers to pay with credit cards, etc.


Now assume we are looking at a large, non-seasonal, steady-state firm (like Proctor and Gamblefor example). For firms like this, ΔI is typically close to zero. Setting ΔI to zero in the aboveequation yields:

(Purchases of I) ~ COGS

With this in mind, we see that AP-T = Accounts Payable (EOP) / COGS should work reasonablywell when applied to large, non-seasonal, steady-state firms experiencing no Inventory Write-Downs.

Good to KnowNotice that, in general, the more approximations we make to our ratios, the more specializedtheir usage becomes. This is an important insight not just for ratios, but for all mathematicalmodels in finance. Many big mistakes in finance are down to the use in models in situationswhere they do not apply. Understanding the simplifying approximations and assumptions of allfinancial models is an absolute prerequisite to using them with confidence.

Cash Level (CL)Cash Level is defined as:

Cash Level ≡ (Cash + Cash Equivalents)EOP / Revenue (CL, expressed as %)

Cash Level measures what percent of a company's annualized sales it is holding in cash.

CL is often used to see if an individual company's cash balance is safe, when compared to theaverage level of its comps. Here are some appropriate ballpark cash levels for entities in severalindustries:

Typical Cash Levels Needed for Safe Running of Business

Company Type Sales Minimum Safe CLManufacturing Big 2% - 4%Technology Big 4% - 20%Start-up Small 20% - 200%

These ranges are imperfect, because a company may have ready sources of cash (or readysources of “liquidity”) that do not appear in its Cash Level Ratio. For example, a firm may havea “Revolving Loan” agreement with a bank for $20MM. The loan allows the company to borrowup to $20MM at any time. (This works like a credit-card loan).

Companies with revolving loans effectively have bigger cash reserves than reported by their theirCL Ratios. For this reason, many analysts compute “Cash and Liquidity” Ratios, which includecash available in revolvers. The amount available through loans is not reported on an entity'sfinancial statements, and must be manually dug out of its SEC 10-K filings.


CL is also used to see if an entity is holding too much cash. Equity investors usually don't like afirm to hold more cash than it needs. This is because the company earns a very low return on itscash pile, and investors feel they could do better themselves. So when a company has extra cash,equity investors would like the firm to transfer this excess to them in the form of dividends.

Debt investors, by contrast, get warm fuzzy feelings when a company has a good stockpile.They like this because it increases the probability that their loan or bonds will be repaid on-timeand in-full. As a result debt holders are often unhappy about a company's issuing dividends toshareholders, and will often write restrictions on this practice into their loan and bond contracts.

EXAMPLE:TURNOVER AND EFFICIENCY RATIOS FOR CAL AND LUVConsider these ratios for CAL and LUV, and answer the questions below.

1. During the past year, on average, who gets the most sales from their assets?Does this make sense? Has this been more-or-less consistently true for past two years?

From the TTM AER Ratios, we see that CAL gets the most revenue per dollar of asset. Thismakes sense because CAL is a full service provider, with first-class, business and economysales. LUV only offers low-cost, economy class seats. CAL has earned more than LUV perdollar of assets for the past seven quarters.

2. Over the past year, on average, who has received the most income from their assets?How do you explain this, given your answer to 1) above?

LUV, based on TTM ROA Ratios. Given CAL's higher AER, LUV's higher ROA must bederived from a significantly lower cost structure.


3. On average over the past year, who provides owners with the most income per dollar ofequity investment? How does your answer change when you look over the past fourquarters individually. What does this tell you about looking at only TTM Ratios?

CAL's TTM ROE is much higher than LUV's. On inspecting quarter-by-quarter, we see thisis because CAL had a huge ROE in Q4, despite generating negative ROE for Q's 1 to 3. Bycontrast, LUV's ROE has been positive for the past four quarters. All this tells us that it isnot enough to look exclusively at annual ratios, especially for seasonal companiesexperiencing volatility in sales. Quarterly and/or monthly ratios should be reviewed as well.

4. On average, who has managed their receivables (AR) best over the past year?Has this been consistently true for past two years?

LUV has done better than CAL during the TTM period, as evidenced by its smaller AR-TRatio. LUV has also done better in each of the past eight quarters.

5. On average, who has managed their payables (AP) best during the past year?Has this been ~ consistently true for past 2 yrs?

Once again, LUV has done better than CAL during the TTM period, as evidenced by itslarger AP-T Ratio. LUV has also done better in six of the past eight quarters.

6. Assuming no impending mergers etc., who has managed cash best over the past year? Why?What inside information from LUV might change your opinion?

Based on the specified criteria, CAL has done a better job, because LUV has clearly beenhanging onto excess cash. In fact, LUV has been accumulating cash over the past two years.If it has been saving up to buy a distressed competitor during a down-market time, thismight have been a smart and proper move.

EXAMPLE: USING CASH LEVEL AND ROE TO HELP IDENTIFY AN ANTI-TRUST LAW VIOLATORRatio Analysis is not just for managers and investors. Lets see how the U.S. Department ofJustice (DOJ) could have used it to help identify Microsoft (MSFT) as anti-trust law violator inthe late 1990s.

First, as usual, here is a little background. In the U.S., an anti-trust violator must exemplify twocharacteristics:

1. It must be a monopolist.2. It must use its monopoly to protect and extend it's monopoly, and to undermine customer

choice.


In the mid 1900's, many computer makers and Netscape Inc. (an Internet browser company) 9

complained to the DOJ that MSFT was unfairly requiring PC makers to promote MSFT's InternetExplorer browser in order to purchase the Windows 95 operating system. Based on theseassertions, the DOJ filed an anti-trust suit against MSFT in 1997. The DOJ argued that computermakers had no alternative to installing the Windows 95 operating system (OS) on their machines,because it was the only OS in common commercial use. Therefore, the DOJ further argued,MSFT's insistence on the promotion of Internet Explorer was an obvious unfair extension of itsmonopoly, aimed at killing Netscape and undermining customer choice.

Part of MSFT’s defense was to claim that it did not have a monopoly on personal computeroperating systems. It pointed to IBM's OS/2 and Linux as alternatives. As the DOJ knew fromits own research, these were weak defenses. OS/2 was probably IBM's most spectacularsoftware failure of all time. Despite a huge effort by the company, OS/2 never caught on withconsumers or small businesses, and was formally dropped in 2001. Similarly, in 1997 Linux wasvirtually unknown to PC users, and in 2013 it still claims only about 2% of the desktop PC OSmarket.10

The DOJ's case against MSFT could be further bolstered with a bit of Ratio Analysis. Here ishow it could work:

First note that the DOJ needed only prove that Windows 95 was a monopoly OS. If this wastrue, then MSFT's required bundling of Internet Explorer with Windows 95 clearly madeMSFT an anti-trust violator (as the DOJ claimed).

Next note that, in general, only a monopolist can enjoy extraordinarily great financialperformance, as measured by ROE or other metrics. This is because a product's high ROEswill drive competitors to market similar offerings – especially in the hyper-competitivetechnology industry. The emergence of new products drives down prices, and lowerseveryone's ROEs to more normative levels. The only way to prevent this chain of events iswith a monopoly or some other barrier to competitors' entry.

Finally, analyze MSFT's revenue and ROE. In 1997, although MSFT enjoyed large salesfrom its office suite of products, the lion's share of its revenue came from sales of itsoperating system software (Windows 3.1 and Windows 95). So, if if the company's ROEwas extremely high and much higher than competitors, this would be prima-face evidence ofthe company being an OS monopolist.

9 The Netscape browser was the first widely-available Internet surfing tool. It radically simplified access to theInternet, and opened up the network to non specialist users for the first time. Netscape was invented by MarcAndresson, who is now a partner at Andresson Horowitz, one of Silicon Valley's most prominent and successfulventure capital funds.

10 http://www.netmarketshare.com/operating-system-market-share.aspx?qprid=10&qpcustomd=0


Performing a 1997 ROE study of large, successful software technology firms (excluding MSFT)we find ROEs mostly grouped between 15% and 25%.11 Microsoft's ROE at the time iscomputed as follows:

At 57%, MSFT's ROE is pretty high compared to similar software companies of the time. Evenso, this number is actually depressed. Note that the firm has $23BB in cash, which is about 1/3 ofits total assets and 39% of its annual revenue (IE: a 39% Cash Level Ratio). This seems awfullylarge, so lets compare it to the cash levels of our large, successful software firms. Computing thecash levels for these firms shows that they are on the order of 3% to 10%.

Lets see how MSFT's 1997 ROE looks if the firm is holding a more reasonable amount of cash,say 5% of sales ($3,021 MM). To get to this level of cash, we could envision MSFT giving itsshareholders a dividend of $20,390 MM as follows:

11 Presented without backup in order to keep the size of this example manageable.


As shown, the cash dividend of $20,390 MM would reduce MSFT's equity by the sameamount.12 This in turn would reduce the denominator of MSFT's ROE Ratio. With the firmholding this more reasonable level of cash, we compute MSFT's ROE Ratio as a whopping154%! This is so high because the firm earns a very small return on its cash as compared to itsother assets. By removing the drag on ROE caused by MSFT's excess cash, we measure theROE generated by just the firm's business operations.

Based on our analysis of industry comps, MSFT's 154% ROE is a clear indicator that its OSsoftware is a monopoly product. If it were possible for other firms to compete with Windows 95,they certainly would, in order to enjoy an ROE closer to 154% than the software industry rangeof 15% to 25%. This analysis would nicely complement the DOJ's market-share study ofWindows 95 vs competing offerings such as OS/2 and Linux.

Postscript:

Microsoft was found to be in violation of antitrust laws, and was required to let PC makersendorse whatever internet browser they chose. This was too late for Netscape, whose browserslid into oblivion. The DOJ's efforts also did not hinder MSFT, which continued its hegemony inOS software until the rise of the smart-phone and the tablet, which run today primarily onGoogle's Android (a variant of Linux) and Apple's iOS.

12 The journal entries for this are:cr Cash $20,390 (A)dr Dividend $20,390 (E)


FINANCIAL AND OPERATING LEVERAGERATIOS

Here is a reminder of our five classes of ratios

1. Revenue and Revenue Growth Ratios.2. Margin Ratios.3. Turnover (Efficiency) Ratios.4. Financial and Operating Leverage Ratios.5. Liquidity Ratios.

Lets continue our review with a look at Financial and Operating Leverage Ratios. FinancialLeverage measures an entity's debt financing relative to some or all of its total financing. It isalso described as a measure of debt relative to income or cash flow. In short:

Financial Leverage ≡

§ Debt Financing / Equity Financing (%), or

§ Debt Financing / Total Financing (%), or

§ Debt / Measure of income or cash flow (Years).

Operating Leverage measures a firm's fixed costs relative to its variable costs. IE:

Operating Leverage ≡ Fixed Costs / Variable Costs

As noted earlier in this chapter, fixed costs are expenditures that do not scale with small ormedium changes in sales. An example for CAL would be the lease payment on one of its jets.The payment remains constant if the plane is running at full capacity or half of that. Variablecosts are expenditures that scale almost linearly with small or medium changes in revenue.CAL's variable costs include the amount if pays caterers for its on-board meal services. Theamount provided and paid for changes directly with the number of passengers flows, and therevenue received from them.

In the limit, all costs are variable. CAL for example can cancel plane leases (by paying apenalty) and lease more planes as passengers-flown decreases or increases, respectively. Toavoid confusion, we will define fixed costs to be any expenditure that a company can not adjusteasily in one quarter of operations; we likewise define variable costs as items that can move insync with revenues during a single quarter.

The key property of Financial and Operating Leverage is that increasing either of them willimprove a firm's financial performance in good times (when revenues are stable or rising andcosts are stable or declining), and decreasing them will impair an entity's performance. Financialand Operating Leverage Ratios are typically set up so that large values imply high levels ofleverage. Accordingly large values indicate upside potential in good times, and increasedbankruptcy risk in bad times.


FINANCIAL LEVERAGE RATIOSFinancial Leverage Ratios are popular among analysts and potential investors, in part because thedata needed to compute them is easy to find in financial statements. The data required for someOperating Leverage Ratios is not recorded on financial statements, and is therefore of more useto company managers and executives.

Debt to Assets RatioThe Debt to Assets Ratio (DtA ratio) is defined as:

Debt to Assets Ratio ≡ Total Debt (long and short term) / Total Assets (DtA expressed as %)

DtA measures how much of an entity's total assets (measured at cost or cost minus wear) werefinanced with debt. A large number implies a high level of debt financing. As with all LeverageRatios, bigger numbers indicate more potential upside for owners in good times, and morebankruptcy risk in bad times.

DtA is a useful measure for any type of firm, but especially for industrial and financial entities.As usual, the appropriate size of the ratio varies by industry and other factors. A regulated utility,for example, can safely enjoy a large DtA Ratio, as its operates as a monopoly with revenues thatare more-or-less guaranteed. A technology start-up, by contrast, should maintain a low DtARatio, as its revenues are subject to relatively wild swings.

Self-Testing Questions1. Can an entity's DtA Ratio be greater than 100%? Why or why not? 2. What is a lower boundon the DtA ratio? Why? 3. What is an upper bound? Why?

Solution1. Yes. This means the company has negative equity. (Recall Equity ≡ Assets – Liabilities).

2. Lower bound is zero, corresponding to an entity with no debt.

3. Upper bound theoretically can approach infinity, for a company with a huge amount of debt.In practice, companies go bankrupt when their debt is so large that they cannot pay intereston it or refinance it.

Good to KnowIts very helpful to perform an analysis similar the one above for all the ratios. Understanding: Ratios ranges, The implications of being near the end of a range, and


The implications of being at a key point in a range is good ammunition for analyzing anyfirm.

EXAMPLE:FINANCIAL LEVERAGE AND PRIVATE EQUITY INVESTORS

Now that we understand what financial leverage is and one way to measure it, lets see how it canbe used and explore its effects.

Consider two sets of investors – the Conservatives and the Cowboys – that are contemplating thepurchase of ToolCo, Inc. ToolCo supplies specialty tools to motorcycle mechanics. The firm has$100MM in assets (in both market-value and GAAP terms) and no debt. Its owners are willingto sell for $100MM.

The Conservatives aim to pool their funds and purchase the firm for $100MM cash. TheCowboys plan to pay the same amount, sourced by using $10MM of their own funds, and$90MM from a loan taken out by ToolCo itself. (The loan is pre-arranged to be taken out assoon as the Cowboys take ownership of the firm. The proceeds of the loan are immediatelydelivered to the prior owners of ToolCo. The loan's interest rate is 10%, and lets say that it wasmade by JP Morgan). After purchasing ToolCo, the firm's Balance Sheet looks like this, for theConservatives and the Cowboys:

Notice that the firm's assets are the same no matter who buys it. The differences in debt andequity are down to the contrasting methods used to finance the purchase of the firm. The DtARatio for the Conservatives-funded firm is 0%, while the Ratio for the Cowboy-funded version isa hefty 90%.

Now consider the firm's Income Statement and ROE Ratio for its first year of operations underthe new management, again for both the Conservatives and the Cowboys. Assuming this is agood year, the ISs and ratios look as follows:


Note that the Conservatives enjoy more Net Income from ToolCo ($15MM vs $8.25MM for theCowboys). However, the Cowboys return on their equity investment ($10MM), as measured byROE, is much higher than the return that the Conservatives realize on their $100MM (82.5% vs15.0% respectively). This is because the Cowboys achieved NI of $8.25MM after investing just$10MM (and paying J.P. Morgan loan interest of $9MM).

$8.25 / $10.00 = 82.5% ROE.

The Conservatives, by contrast, paid no interest and achieved NI of $15MM, but they invested10 times more than the Cowboys to achieve this result.

$15 / $100 = 15% ROE.

Based on what we've seen so far, it seems like the Cowboys have the best investment strategy byfar. But consider how things would look if ToolCo experienced a bad year after being purchased.Specifically, consider how things would look if ToolCo realized revenue of $30MM instead of$50MM:

Even with a drop in revenue of 40%, the Conservative-funded version of ToolCo enjoys positiveNet Income and ROE ($3.75MM and 3.8%). By contrast, the Cowboy-funded incarnation of


ToolCo looses $3MM during the year; if these losses were to continue, ToolCo would run out ofcash and be forced into bankruptcy.

The moral of this story is, as asserted above, increased leverage increases financial performancein good times, but increases bankruptcy risk in bad times. In this case the Conservatives willprobably get a lower return on their investment than the Cowboys under most circumstances, butthey will enjoy a much smaller probability of “flaming out” if things go badly for ToolCo.

As you've probably guessed, the Cowboys' approach is close to the method that Private Equityinvestors use to purchase companies. Although the strategy looks risky, it carries benefitsbeyond generating high ROEs during good times. Assuming the Conservatives and Cowboys areequally “capitalized” (IE: they both have $100MM of their own money to spend), the Cowboyscan buy nine other entities of ToolCo's size. This could give the Cowboys a diversified portfolioof companies with less overall risk than the Conservatives 'all our eggs in one basket' investment.Additionally, the Cowboy's risk is reduced by the quick “payback” on their investment. Say thatToolCo runs well for two years. At the end of this time the Cowboys will have received$16.5MM in Net Income on their $10MM investment. If ToolCo then has a horrible year andcan't pay the interest payments on its loan, the Cowboys can simply surrender the firm to J.P.Morgan (the lender), and walk away with a profit of $6.5MM. Of course, in this case theCowboys would need to find an alternate lender for their next deal.

Debt to Capitalization RatioBefore defining the Debt to Capitalization Ratio (DtC), you should know that “capitalization”refers to a firm's total debt and its equity. IE:

Capitalization ≡ Total Debt + Equity

With this in mind, the DtC Ratio measures a firm's debt relative to it capitalization.Mathematically, the ratio is defined as:

Debt to Capitalization Ratio ≡ Total Debt (long and short term) / (Total Debt + Equity)(DtC, expressed as %)DtC = Total Debt (long and short term) / (Capitalization)

As with the DtA Ratio, a large number implies a high level of debt financing, and biggernumbers indicate more potential upside for owners in good times, and more bankruptcy risk inbad times. DtC is a useful measure for any type of firm.

Debt to EBIT RatioThe Debt to EBIT Ratio (DtEBIT) measures an entity's debt relative to earnings available to paydown debt. It is defined as:

Debt to EBIT ≡ Total Debt(EOP) / EBIT (DtEBIT , expressed in years).


As we know, EBIT is short for Earnings Before Interest and Tax, and is the amount of earningsan entity has available to pay interest, taxes, shareholder dividends, etc.

DtEBIT's units are years. Quarterly EBIT must be annualized (multiplied by four) to maintainconsistent units.

DtEBIT tells us about how many years it would take an entity to amortize (pay off) all its debt, ifall its EBIT could be devoted to this task.

Like most other ratios, DtEBIT is imperfect. In the real world, it is rare for companies to put alltheir EBIT toward amortizing debt, because (for example) they have to pay interest on theiroutstanding borrowings. Also, unless they are unprofitable they will have to pay some taxes.

OPERATING LEVERAGEAs noted above, Operating Leverage measures an entity's fixed costs relative to its variable costs.Also, we will consider fixed costs as expenditures that cannot be easily adjusted during onequarter of operations. We likewise define variable costs as those that may move in sync withrevenues during a quarter.

Operating Leverage is similar to Financial Leverage, in the sense that higher levels of either onemay produce better financial performance in good times but increase bankruptcy risk in badtimes. So, as you may suspect, the two types of leverage are not completely independent.Interest Expense, for example, is related to Financial Leverage, but it is also a fixed cost. To geta feel for how Operating Leverage works and how it differs from Financial Leverage, lets look atan example.

OPERATING LEVERAGE EXAMPLE: WEA VS CARPENTER

Lets compare and contrast the investment management business of West End Advisors (WEA)with a carpenter's operations. Here are BOY Balance Sheets and two sets of annual IncomeStatements for both firms:


Note that:

The firms start the year with identical, debt-free Balance Sheets. The absence of debt willensure that performance differences will not be influenced by Financial Leverage.

WEA has no variable costs. It must pay its rent, employees, etc irrespective of how muchmoney it manages.

The carpenter has fixed and variable costs. Rent on her shop, for example, is a fixed costwhile her diesel fuel expenses will vary with the number of jobs she takes on and herrevenue.

Looking at each firm's Income Statement for a “Good Year,” we further see that revenues, totalexpenses, Net Income and ROE are the same for both firms. However, WEA's ratio of fixedcosts to total costs is 100%, while the carpenter's is just 50%.

The “Bad Year” ISs show a divergence in the two firms performance. Although revenue is thesame for each firm ($25K), WEA's fixed costs have not declined. As a result, its Net Income iscut quite drastically (from $22.5K to $3.75K), and its ROE is accordingly depressed (droppingfrom 22.5% to 3.75%). By contrast, the carpenter's Net Income only dropped to $7.5K, and herROE only dropped to 7.5%). She outperformed WEA because she scaled back her variable costsin proportion to her dropping revenue. Because she could not reduce her fixed costs ($10K), herratio of fixed to variable costs has climbed from 50.0% to 66.7%. WEA's fixed/variable costratio of course remains at 100%.


WEA's high fixed cost structure clearly hurts it when times are tough. In good times, the samestructure will help it outperform the carpenter, as shown in these “Very Good Year” annualIncome Statements:

In this case WEA outperforms, as seen in its 41.3% ROE vs. the carpenter's 37.5%. WEA doesbetter because its costs do not increase, even as its revenue climbs from $50K to $75K. Thecarpenter's variable costs move up with her increased sales, which holds down her Net Incomeand her ROE. Here WEA's fixed/variable cost ratio remains at 100%, while the carpenter's hasdeclined to 40%.

Finally, its interesting to consider a scenario where market conditions for WEA and the carpenterget better and better. In this situation, WEA's revenues can grow indefinitely, and the firm willenjoy ever improving ROE. By contrast, the carpenter’s revenues, profits and ROE will stall.Why? At some point, the carpenter will book all her working hours and have to turn downadditional jobs and revenue. (In this case we ignore her possibly hiring another worker, whichwould fundamentally alter the financial structure of her business). On the other hand, WEA'swork is almost the same for managing small amounts of money as for large amounts. This isespecially true if increases in funds-to-manage come from the firm's existing customers.

Entities like WEA are said to have “high fixed cost” business models that “scale efficiently.”High fixed cost, efficient scaling businesses are sought after by savvy entrepreneurs and VentureCapitalists alike, because they ensure the possibility of unhindered growth and increasingprofitability.

Measuring Operating LeverageIn the above example, WEA and the carpenter had conveniently separated their costs into fixedand variable categories. GAAP accounting does not require that firms provide this breakdown.As a result, most firms to not publish this information with their financial statements or


anywhere else that outsiders can access. (This is partly because of the work involved and partlybecause publishing it would unnecessarily give competitors useful information).

For analysts and investors who must rely exclusively on firms' financial statements for RatioAnalysis, fixed to variable cost ratios (Operating Leverage Ratios) are approximated usingGAAP-based information. Our next ratio is a good example.

SDI to COGS Ratio (SDItC)The SDI to COGS Ratio (SDItC) approximately measures an entity's fixed costs relative to itsvariable costs. “SDI” stands for SGA, Depreciation and Interest expenses. Mathematically, theratio looks like this:

SDI to COGS ≡ (SGA + Depreciation + Interest) / COGS (SDItC, expressed as %)

SGA, Depreciation and Interest are proxies for the entity's fixed costs. Depreciation and interestare better proxies than SGA. Clearly, interest payments and depreciation will not scale quicklywith sales. Much of SGA, such as accounting department salaries and headquarters rent, alsodoes not move in sync with sales. However, some pieces of this expense, like advertising, mightclosely track revenues.

As we know, COGS tracks sales very closely. The downside of using COGS to track variableexpenses is that it makes this ratio useless for service and financial firms, which have noinventory. As a result, the SDItC Ratio is only useful for industrial entities.

EXAMPLE:LEVERAGE RATIOS FOR CAL AND LUVConsider these ratios for CAL and LUV, and answer the questions below.


1. Looking at the past year, which firm has the higher level of debt financing?

To answer this question, we could use either the Debt to Assets Ratio or the Debt toCapitalization Ratio. Choosing the DtC Ratio, we see in the TTM column that CAL is muchmore levered than LUV. (Cal has a 77.2% DtC Ratio, vs 23.4% for LUV).

2. Which firm has the higher Operating LeverageHow do you reconcile this with your answer to 1) above?

From the two firms' SDItCOGS Ratios, we see that LUV has more Operating Leverage(28.2% SDItCOGS for CAL vs 36.2% for LUV). As we know, SDItCOGS is not directlymeasuring debt, so this result is entirely possible, irrespective of each firms FinancialLeverage.

3. Based on your answers to 1) and 2) above, and sales trends for both companies for the pasttwo years, which firm would you rather lend your money to? Why?

Our above analysis tells us that CAL is by far the more financially levered firm, and this factswamps the relatively modest differences in Operating Leverage. So CAL is the higher risk,higher potential reward entity. As seen in the above table, the sales trends for both firms aregood. So the decision as to which firm we would rather lend to comes down to our risktolerance. High-risk investors might choose to lend to CAL – demanding a higher interestrate in exchange for taking on its high bankruptcy risk. Risk averse investors, by contrast,may choose to lend to LUV, accepting a lower interest rate in exchange for not having toworry about bankruptcy risk.

4. Looking at the past eight quarters, has one (or more) firm’s financial ‘leverage position’


significantly improved or deteriorated? Explain.

By reviewing each entity's DtC Ratio, we see that CAL has reduced its leverage while LUVhas slightly increased its debt as a percentage of its capitalization. CAL's reduction may bean attempt by the company to reduce its bankruptcy risk during a period of declining andnegative Net Income (as we saw when doing Margin Analysis of both firms). LUV could beincreasing its leverage for many reasons, but it is probably just aiming to increase its ROE.

5. Based on TTM figures, about how many years would it take for each company to pay off itsdebt, if it put all reasonably-possible effort into this task?

Using Debt to EBIT Ratios, we find 11.4 years for CAL, and 2.3 years for LUV.

6. Considering all the Ratio Analysis we have done so far, which firm is riskier? Why?

Overall CAL is clearly the most risky firm, as measured by (among other things) itserratic/negative profit margin, its Debt to Capitalization, and its Debt to EBIT.


LIQUIDITY RATIOS

Liquidity Ratios comprise our final class of Ratio Analysis tools. Before delving into them, letsclarify what we mean by “liquidity.”

Liquidity is used to mean several things, depending on context and intent. The most generaldefinition of liquidity is “a measure of firm’s ability to quickly produce cash, to meet (certainand/or potential) short-term obligations.” Here is an example illustrating this use of the term:

In Q4-2008, Treasury Secretary Henry Paulson outlined the Treasury’s proposal to providean unlimited amount of liquidity to Fannie Mae and Freddie Mac. He defended the unlimitedallocation as follows:

"If you've got a squirt gun in your pocket and people know that, you may have to take it outand use it," he said. "But if you've got a bazooka, you may not have to take it out."

A more specialized definition of liquidity is “the ability to quickly convert an investmentportfolio to cash with little or no loss in value.” This quote from the Wall Street Journal in Juneof 2008 shows how the term was used to help describe the fall of Bear Stearns:

“$40BB of Bear Stearns’ portfolio was illiquid – comprised of CDOs and other inscrutablesecurities for which no one would bid.”

(FYI, in August 2008, Citibank sold a similar portfolio for $0.22 per $1.00 face amount).

Liquidity Ratios measure an entity's sources of cash relative to its near-term cash obligations.Operating sources of cash include, for example:

Current Assets. Cash Flow from Operations. Revolving Lines of Credit.

Examples of near-term cash obligations are:

Current Liabilities. Cash Flow into Operations (for operations that are losing money). Interest Expense.(Note that depreciation is not a cash obligation).

Current Ratio (CR)Current Ratio (CR) measures current assets relative to current liabilities. It is definedmathematically as:

CR ≡ Current Assets / Current Liabilities


The ratio puts the assets an entity expects to turn into cash within a year in the numerator, andthe firm's cash obligations coming due within a year in the denominator. Typical usage issomething like “our Current Ratio is 1.7”. As with virtually all Liquidity Ratios, bigger is better,within reason. The Current Ratio is applicable to all types of entities.

Looking at the components of the CR, you might think that a ratio of less than 1.0 would be abad sign. This is usually but not always true. As we saw with the Cash Level Ratio, a firm maybe able to raise cash quickly through a revolving loan, although this ability to borrow is notrecorded as a current asset. In this case the firm may carry a CR of less than zero, but haveplenty of liquidity.

Working Capital Ratio (WCR)To discuss the Working Capital Ratio (WCR), we first need to define “Working CapitalAccounts” and Working Capital. A firm's Working Capital Accounts include all its asset andliability accounts that are associated with its day-to-day business. This includes both currentaccounts and non-current accounts. Assets and liability accounts that are associated withfinancing or investment are not Working Capital Accounts, whether they are current or non-current.

Working Capital accounts include, for example:

Accounts Receivable, Inventory, Accounts Payable, and Pre-Paid Expenses (even if non-current).Examples of non-Working Capital accounts include: Short term Portion of Long Term Debt,PPE, and all equity accounts.

Next up, we need to define Working Capital. This is simply the difference between a firm'sWorking Capital assets and its Working Capital liabilities:

Working Capital ≡ Working Capital Assets – Working Capital Liabilities

Working Capital measures how much more cash and normal-business, soon-to-be-cash assets anentity has than normal-business, soon-to-be-paid liabilities. I think of this as roughly like theexcess normal-business, soon-to-be-cash assets an entity has.

Good to Know:A firm's Short Term Investments account may or may not be a Working Capital Account. If indoubt, to be safe, this account should be excluded from Working Capital.Why? Consider that a given company’s Short Term Investments may include, for example:

CDs, short-term treasuries, and similar instruments, or Long-term bond investments that happen to be maturing soon, and long-term stock

investments that the entity has recently decided to sell.


The first set of items are properly part of working capital, but the second set are investment-related items that should be excluded.

Here is a real-world example:For many years, Ford owned about 20% of Mazda's stock, which it reported as a Long-TermInvestment on its Balance Sheets. In 2010, Ford announced its intent to sell most of this stake.On the company's next Balance Sheet, Ford properly reported the stock as Investment Held forSale. This was clearly not a Working Capital Account, even though it was a current asset.However, many services that provide condensed financial statements to investors and analyststhrew the investment amount into Ford's Short Term Investments account. This erroneouslyinflated the value of Ford's Working Capital assets.

The moral of this story is to be careful about what you include in Working Capital Accounts. Ifin doubt make conservative assumptions or look up detailed financial reports at the SEC'swebsite.

Finally we are ready to look at the Working Capital Ratio (WCR). The WCR measures a firm'sWorking Capital relative to its Working Capital assets. IE:

Working Capital Ratio ≡ Working Capital / Working Capital Assets

This ratio measures the excess of an entity's day-today, operating business assets, as a percentageof its total day-today, operating business assets. It is a useful ratio for all types of entities, withthe caveat that it may be omitting liquidity in the form of an undrawn loan.

Fixed Cost Ratio (FCR)The Fixed Cost Ratio (FCR) aims to measure earnings available to pay interest, relative tointerest obligations. It is defined mathematically as:

Fixed Cost Ratio ≡ EBIT / Interest

In general, the FCR should be greater than 1. Lower values indicate that a firm's operations arenot generating enough earnings to pay the interest owed on its debt.

EBITDA Sustainability Ratio (EBITDA-S)To tackle this ratio, lets first define EBITDA and remind ourselves what CAPX is. EBITDAstands for “Earnings Before Interest, Taxes, Depreciation and Amortization.” A firm's EBITDAshould always be positive. Negative EBITDA suggests that an entity may not be able to meet allits financial obligations.

Recall that CAPX is short for Capital Expenditures, and represents net cash payments for PPE.CAPX is reported on the “Cash Flows from Investing” portion of a firm's Cash Flow Statement.For a large entity operating in a “steady state” capacity, CAPX over a quarter or year should besimilar to depreciation measured over the same time-frame.


With all this in mind, the EBITDA Sustainability Ratio (EBITDA-S) is defined as:

EBITDA Sustainability Ratio ≡ EBITDA / (Interest + CAPX)

The ratio aims to measure how much earnings a firm makes available to pay unavoidable costs(costs that ensure the entity's medium-term sustainability). Expenditures other than interest andCAPX are arguably not imperative for ensuring a firm's financial future. Depreciation, forexample, is never a cash expense. Similarly, a firm will incur no Tax Expense if it is justscraping by. By contrast, interest is crucial because a missed payment (a “default”) may triggerbankruptcy. CAPX is also essential in the medium term, because it is used to maintain a firm'sPPE.

The Sustainability Ratio is useful for all types of entities, even those with little or no PPE. Forfirms with no PPE, the CAPX term will drop out and depreciation will be zero, reducing thisratio to something like the Fixed Coverage Ratio: EBIT / Interest.

A weakness in the EBITDA-S Ratio is found in its CAPX term. In terms of sustainability, we areonly concerned with “maintenance CAPX.” This is the amount of CAPX an entity needs toinvest to keep its PPE operating properly. Reported CAPX may be significantly higher thanmaintenance CAPX for healthy, growing companies, which are investing in new PPE. Similarly,an unhealthy entity's CAPX may be distorted by sale of PPE while downsizing. An unhealthycompany may also postpone its PPE maintenance, and report a small level of CAPX that is notsustainable. So, as with many ratios, we must be careful in our use of EBITDA-S, and performadditional research to understand its constituent parts.

Our last two ratios, the Nominal Interest Rate and Depreciation Test, are not true LiquidityRatios. I include them with the Liquidity Ratio class because they both provide informationabout the financial sustainability of an entity, which is what Liquidity Ratios are often used tomeasure.

Nominal Interest Rate (NIR)The Nominal Interest Rate (NIR) measures the average annual rate of interest that an entity payson all its debt. Mathematically:

Nominal Interest Rate ≡ Interest Expense(annualized) / Total Debt(BOP) (NIR, expressed as %)

Units are annual (% per year). This implies as usual that quarterly interest must be multiplied byfour to obtain annual units.

The NIR is an appropriate ratio for any type of entity (Industrial, Service, or Financial). Ingeneral, the smaller the NIR the better, and an NIR that is decreasing over time is better than aratio that is increasing. However, these notions need to be tempered by general bond marketconditions. In 2013 for example, corporate bond interest rates rose across the board, making itdifficult for any single entity to reduce its NIR.


Depreciation Test (DT)The Depreciation Test Ratio (DT) measures an entity's depreciation in a period relative to itsCAPX:

Depreciation Test ≡ Depreciation / CAPX

The DT Ratio for rapidly growing companies will usually be less than one, as they add to theirPPE. Large, steady-state firms may ofter report a ratio of about one. A DT Ratio larger than onemay indicate that an entity is under-maintaining its CAPX and therefore impairing its medium-term sustainability.

EXAMPLE:LIQUIDITY RATIOS FOR CAL AND LUVConsider these ratios for CAL and LUV, and answer the questions below.

1. Based on TTM results, which company best plans for its near-term obligations? Is the othercompany unsafe?

Using the Current Ratio, we see that CAL appears to be better prepared (with a CR of 1.04vs 0.93 for LUV). Even with a CR of less than 1.0, LUV is not unsafe. We should keep inmind that the CR may not be telling the whole picture, as LUV may have (for example) anundrawn credit facility that could use to meet some near-term obligations.

2. Is the trend in CAL’s EBITDA-S Ratio good or bad? Are recent levels of this ratiosustainable?

The trend is clearly bad. CAL's Q6 vs Q2 EBITDA-S Ratios are 125% to 38%, and Q5 vs


Q1 is equally as alarming. CAL's current EBITDA-S Ratio is clearly unsustainable. In Q1(its most recently reported quarter), the company earned only 54% of its Interest Expenseand CAPX.

3. How would you rate CAL’s interest-rate management over the past seven quarters (good,neutral, bad)? Why?

CAL's interest rate has been holding relatively steady, and has declined significantly in thepast quarter. This is a pretty good achievement for a company facing the headwinds wehave discussed throughout this chapter. For these reasons I'd give CAL a “good” grade.

4. What does LUV’s TTM DT Ratio say about its growth? Is this consistent with its revenueand its overall financial state?

LUV's DT shows that the company is expanding its PPE base (IE: increasing its fleet ofplanes). This makes sense, given the firm's healthy financial state and its annual revenuegrowth of about 12%. LUV's strategy may be expand capacity while others in the industryare weak.

5. Has CAL’s management of its Capital Expenditures improved over the past three quarters?Why or why not?

Yes. A year ago, CAL was underfunding its CAPX, as measured by its DT Ratios of 131%to 152%. By contrast, in two of the past three quarters its DT Ratio has been less than 57%,indicating that it has tried to catch up on CAPX payments and PPE maintenance.


CHAPTER APPENDIX

CAL’S FINANCIAL STATEMENTS USED FOR THE

ABOVE RATIO ANALYSES.


FINANCIAL STATEMENT ANALYSIS

PART II:RATIOS DERIVED FROM MARKET

DATA AND FINANCIAL STATEMENTS

CHAPTER 14

CHAPTER14–RATIOSDERIVEDFROMMARKETDATAANDFINANCIALSTATEMENTS PAGE1Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

EQUITY (STOCK) INVESTING BASICS

Before we start studying ratios that include data from stock markets, lets consider the basics ofequity investing, and compare some key stock market quantities to their GAAP accountingequivalents.

Firstly, the stock marketplace meaning of “equity” is not the same as the meaning in GAAPaccounting. Recall that in GAAP accounting,


In the stock market, equity refers to ownership of a company. Shares of stock represent slices ofownership. If someone purchases all the shares of an entity's stock, they become the sole ownerof the firm. In stock markets, shares are freely traded, implying that the ownership of companieswho's shares trade in these markets have constantly changing ownership profiles.

Equally important, as we have seen when using the Balance Sheet Valuation Method, themarketplace constantly values each company whose stock is traded in it. At all times, themarket's estimate of a company's worth is:

Value of Company ≡ EquityMV = Share Price * Number of Shares Outstanding

As we know, EquityMV is unrelated to EquityGAAP.

EQUITY INVESTING EXAMPLE, SMALLCO

Lets consider a year in the life of SmallCo Inc. At BOY 1, SmallCo:

Raises $100MM cash for 100% ownership of the company, by issuing 100MM shares ofstock at $1/share.

Has this GAAP Balance Sheet ($MM UON):Cash $100 Equity (PIC) $100

Lists its shares of stock (pieces of its ownership) for trading on OTC-Link, and SEC-sanctioned over-the-counter market.1

As SmallCo operates through year one, some of its stock is bought and sold on OTC-Link. Atthe end of the year (EOY 1):

SmallCo reports annual Net Income of $10MM SmallCo publishes its GAAP, EOY 1 Balance Sheet:

Assets $110MM

Liabilities $0MM

Paid in Capital $100MMRetained Earnings $10MM

1 Unlike the NASDAQ and NYSE marketplaces, OTC-Link has no listing requirements. IE: virtually anyAmerican' company's stock can be traded on the OTC-Link platform. http://www.sec.gov/answers/pink.htm


Total Equity $110MM OTC-Link reports SmallCo's closing stock price at $2/share.

At EOY 1, SmallCo's EquityMV is uncoupled from its EquityGAAP. The company's GAAP equity,as reported on its Balance Sheet, is $110MM. The market valuation of the firm is, as always,equal to the product of its outstanding shares of stock and the price that the shares trade at. IE:

EquityMV = 100MM * $2 = $200MM

Ratios derived from market data combine some of these market quantities (EquityMV, price pershare, etc) with data from GAAP financial reports to help investors decide whether to buy, hold,or sell an entity's stock (IE: whether to buy, hold, or sell an ownership stake in the entity).Specifically, stock investors use market-data ratios to help answer questions like:

Is marketplace’s valuation of a company's worth correct? If not, will the marketplace’s value converge to my view of the correct value?

Answers to these and similar questions are crucial for stock investors. Its worth noting that thesequestions are generally more difficult to answer than the questions we've addressed usingfinancial-statement-based ratios. Financial-statement-ratios are good for the needs of most debtinvestors, who what to answer these kinds of questions:

Will the company do well enough to pay me back? How risky is this company compared to its comps? Which company's bonds should we buy? Which is the best company to make a loan to?

Stock investing, because it relies on equity valuation and volatile data (such as stock prices),requires more tools (like ratios incorporating market data) and a willingness to take morerisk.

Equity investors can be broadly grouped into three categories:

1. Value InvestorsValue Investors aim to determine the worth of a given entity, and may choose to purchaseshares of its stock if they believe the company's market valuation (EquityMV) is less than thefirm's true value. Value investors use tools like the Balance Sheet Valuation method.Practitioners include Warren Buffet, Mario Gabelli, and Meryl Witmer.

2. Relative Value InvestorsThese equity investors analyze most companies in an industry or economic sector, andpurchase shares of entities' that they think will outperform their peers.

3. Growth InvestorsGrowth investors search for the fast growing companies, whose value should increase alongwith their market shares and the scale of their operations. Examples growth companiesinclude Twitter, FaceBook and 3D Systems.


RATIOS DERIVED FROM MARKET

DATA AND FINANCIAL STATEMENTS

Now lets look at some ratios that incorporate stock market data as well as financial statementinformation. First up is a new take on ROE:

Return on Equity(Market Value) Ratio (ROE(MV))ROE(MV) measures how much Net Income an entity generates relative to its BOP stock marketvalue. Mathematically, its defined as:

ROE(MV) ≡ NI(annualized) / Equity(MV, BOP) (ROE(MV), expressed as %)

Note that this ratio is the same as our previous incarnation of ROE, except that Equity (MV, BOP) hasreplaced Equity(GAAP, BOP) in the denominator. ROE(MV) is a useful ratio for all types of entities. Aswith traditional ROE, most investors would ideally like to see ROE(MV) positive, large andgrowing.

Price to Earnings Ratio (PE)The Price to Earnings (PE) Ratio is probably the most commonly used ratio in equity analysis. Itmeasures the amount shareholders pay for each dollar of a company's Net Income.Mathematically, the PE Ratio is defined as:

Price to Earnings ≡ Equity(MV, Today) / NI(annualized) 1a)

The PE Ratio is almost the same as 1/ ROE(MV). The difference is that, Equity(MV) is measured asof today for the PE, but is measured at BOP for ROE (MV).

On a per-share basis, the PE ratio is written as:

PE = Price-per-Share(Today) / Earnings-per-Share(annualized)

where Earnings-per-share is approximately NI / (Number of Shares Outstanding). 2 Bymultiplying the numerator and denominator by Number of Shares Outstanding, this version ofthe PE becomes the same as 1a) above.

There are several common methods of computing PE ratios. Here are two common ones:

1. PE(Historical) ≡ Equity(MV, Today) / NI(TTM)

Where “TTM” stands for “Twelve Trialing Months.” This version uses the most recentlyreported twelve months worth on Net Income (or the past four quarters NI if measuringquarterly).

2 I say “approximately” because there are several commonly-used measures of “shares outstanding.” Onemeasure includes, for example, shares that would be outstanding if all options owned by an entity's employeeswere excersized. The detailed discussion of this topic is beyond the scope of this introductory text.


2. PE(Forward) ≡ Equity(MV, Today) / NI(TFM)

Where “TFM” stands for “Twelve Forward Months.” This version uses the Net Income thata company is estimated to deliver in the next twelve months (or the next four quarters ifmeasuring quarterly).

Neither of these versions is ideal. Note that the second variant of the PE requires an estimate ofthe entity's future Net Income. As a large cadre of equity analysts can confirm, this is usuallyvery difficult to predict. On the other hand, while the entity's NI (TTM) is reported on its IncomeStatements, its not clear that the future will look like the past and that this historical number saysmuch about the entity's future performance.

Interpretations of PE ratios can vary widely among analysts and investors. A company with alow PE, for example, will inevitably be interpreted by some as an entity whose stock is selling atbargain prices. To others, it will mean that the company is troubled and should be avoided.

A good example of how disparate equity investors' views can get was seen in a ColumbiaUniversity Business School symposium held around 2006. Bill Miller, an invited speakercelebrated as one of the best value investors of his generation, mentioned that Kodak was one ofthis best stock picks. Jim Chanos, the next speaker and arguably the best “short selling” hedgefund manager of his time, quickly countered that Kodak was among his most important short-sale trades. (A “short seller” sells shares of a company's stock that he does not own, in the hopethat he can buy them back later at a lower price). Chanos turned out to be right – Kodak's stockdropped from 35 to about 5 during the next year, but at the time it was unclear to this audiencemember who was right.

EQUITY ROE AND PE EXAMPLE

a) Assume that the date is 7/1/2008. Using the data below, compute ROE and TTM PE ratiosfor CAL and LUV, as of 6/30/2008.

b) Which company would you prefer to make an equity investment in? (Which company’sstock would you prefer to buy?) Why?

Entity * Equity(MV, BOP) NITTM Price/ShareEOP EPSTTM ROEMV PETTM

CAL $4,081 $126 $11.6 $1.39 3.1% 8.4

LUV $10,939 $629 $11.9 $0.55 5.8% 21.6

* $MM except per share amounts and ratios. Data From Yahoo Finance.

Solutions:a) ROE, CAL: ROEMV = NITTM / Equity(MV, BOP) = $126 / $4,081 = 3.1%

LUV: = $629 / $10,939 = 5.8%


PETTM, CAL: PETTM = Price/ShareEOP / EPSTTM = $11.6 / 1.39 = 8.4

LUV: = $11.9 / 0.55 = 21.6

b) The answer depends on your investment methodology. For example, value investors maymake different choices than growth investors.

Note that, during the past year LUV produced higher earnings per dollar of BOP marketvalue than CAL(as measured by ROEMV). However, based on today's prices per share (orEquity(MV, EOP)), each dollar of LUV's TTM earnings costs almost three times as much asCAL's (as measured by PETTM). Given these data, potential investors may ask, for example,“should we pay up for LUV, assuming that it will continue to outperform CAL on an ROEbasis, despite its relatively high PE ratio?” Wading through data like these and questionslike this are everyday challenges for equity investors.

Dividend Yield (DY)Dividend Yield (DY) measures what percentage of an entity's market value has recently beendistributed to owners as dividends. IE:

Dividend Yield ≡ Dividend (annualized) / Equity(MV, EOP) (DY, expressed as %)

= Dividend per Share(annualized) / Price per ShareEOP

DY is a ratio that is applicable for all entity types. It is most important for large, slow-or-medium growth companies, because, smaller faster growing entities tend not to pay dividends.(These entities usually plow any excess cash into growing their business). For applicablecompanies, bigger is better for this ratio. All else being equal, stock investors prefer companieswith higher dividend yields.

Payout Ratio (PR)The Payout Ratio (PR) measures how much of an entity's Net Income it distributes to itsshareholders as dividends. Mathematically, it is expressed as:

Payout Ratio ≡ Dividend / NI ( PR, expressed as %)

= Dividend per Share / EPS

The PR has the same applicability as the Dividend Yield ratio.

FYI, REITs maintain their no-income-tax status by monitoring a very similar ratio. REITsmeasure payout as Dividends divided by Taxable Income (instead of Net Income). They qualifyto avoid income tax by keeping this ratio at 90% or more, on an annual basis.


Debt to Enterprise Value Ratio (DtEV)Before jumping into this ratio, lets define Enterprise Value (EV) as the sum of an entity's totaldebt and the market value of its equity. IE:

Enterprise Value ≡ Total Debt + Equity(MV)

Note that EV is similar to Capitalization. The only difference is that EV measures equity on amarket-value basis, instead of on a GAAP basis.

EV represents what you may pay to purchase 100% of a firm, assuming the entity's lenders havea “change of control put.” A change of control put gives lenders the right to makeloans/bonds/etc fully due if the controlling ownership of a firm changes. This protects lendersfrom new owners that may be disinclined to make debt payments a top priority.

For example, lets say you are the 100% owner of WEA, and the firm has an outstanding loanfrom J.P. Morgan for $6,000. Now you agree to sell me the firm for $12,000. J.P. Morgan,thinking me unsavory,3 exercises its right to demand repayment of the loan ($6,000) at the timeof sale. In this case, I would have to either pay $18,000 for the firm ($12,000 to you and $6,000to J.P. Morgan) or find another lender to loan WEA $6,000. The proceeds of the new loan wouldbe used to pay off J. P. Morgan.4

Now lets get back to the Debt to Enterprise Value Ratio (DtEV). This ratio measures debt as apercentage of enterprise value. Mathematically:

Debt to Enterprise Value Ratio ≡ Debt(long and short term) / (Debt + EquityMV)

= Debt / Enterprise Value ( DtEV, expressed as %)

DtEV is a leverage ratio, which is similar to the Debt to Capitalization ratio. The only differenceis that DtEV replaces GAAP equity with EquityMV. As with virtually all leverage ratios, biggervalues indicate greater financial rewards for owners in good times, but more downside risk inbad times. DtEV is applicable to all entity types.

Enterprise Value to EBITDA Ratio (EvtEBITDA)Enterprise Value to EBITDA Ratio (EvtEBITDA) measures how many years it would take togenerate a firm’s EV, if 100% of its EBITDA could be devoted to this effort. It is computed as:

Enterprise Value to EBITDA Ratio ≡ EVBOP / EBITDA(annualized)

(EvtEBITDA, expressed in years)

This ratio is a distant cousin of the Debt to EBIT leverage ratio covered in the last chapter.Higher values of EvtEBITDA generally indicate higher financial risk.

3 Arguably with good reason.4 There are actually many other possibilities. For example, I may find a bank to loan WEA $15,000. In this case,

I would invest just $3,000 of my own capital to purchase the firm. The loan proceeds would be used to pay theyou (the existing owner) and J.P. Morgan (the lender).


EXAMPLE:USE OF EVTEBITDA IN RESOLVING CHAPTER 11 BANKRUPTCIES

Here is a simplified explanation of how an entity falls into bankruptcy: It takes out loans and/or issues bonds. These contracts typically give lenders (creditors) the

right to demand immediate, full reimbursement if the entity misses an interest or principalpayment. The contracts further give lenders the right to take ownership of the company ifthe borrower cannot fully reimburse them. (Think of the bank foreclosures in The Grapes ofWrath).

The borrowing entity performs poorly, and “defaults” on one or more debt payments.(“Default” means “miss a payment”).

To avoid immediately losing ownership of the entity, its owners file for Chapter 11bankruptcy protection5 in a Bankruptcy Court. If accepted, this filing prevents takeover bythe entity's lenders for a period of nine months or more. During this time, the entity isallowed to continue operating.

In return for receiving Chapter 11 protection, the entity agrees that a bankruptcy judge will: Control its operations. Determine which creditors will be paid when. Decide how to change the entity's financial structure to avoid another bankruptcy filing

in the future.

Bankruptcy judges and their advisors use EBITDA and EvtEBITDA to help establish a properfinancial structure for firm's in Chapter 11 protection. Here is how it works:

Say HCP misses a bond payment and files for Chapter 11 bankruptcy protection.

At the time of filing, the firm’s bondholders are owed $800MM, and the company's TTMEBITDA is $100MM.

Irrespective of what the bondholders are owed, the bankruptcy judge will establish a newfinancial structure for HCP (IE: a new mix of debt and equity), which will keep the firmfrom falling into bankruptcy again. The judge will reduce the amount of HCP's debt andinterest payments to make this work.

The judge computes the average EVtEBITDA of HCP's financially-healthy competitors as 6.She concludes that HCP should be able to operate sustainably with the same EVtEBITDAratio, assuming its EV is not to heavily weighted toward debt.

The judge now estimates HCP's Enterprise Value as follows:

EV = EVtEBITDA * EBITDA = 6 * $100MM = $600MM

Given that HCP's creditors are owed $800MM, she rules as follows: HCP's current shareholders will be wiped out, and have no ownership of the

restructured company. HCP's creditors will take a $200MM “haircut” and receive $600MM of new debt and

equity (stock) in the new company.

5 Another type of filing, Chapter 7, protects firms with no hope of future viability to wind down their operationsand liquidate in an orderly way.


To ensure that HCP does not have too high a debt and interest payment burden goingforward, the judge declares that creditors will get (say) $300MM in new debt and 100%of the company's stock, which she values at $300MM. Now the firm's total debt andequity add to $600MM, equal to the judge's estimated Enterprise Value.

In summary, the judge estimates HCP's Enterprise Value at $600MM, all of which islegitimately claimed by the firm's lenders. In order to keep HCP's future interest paymentsmanageable, she cuts its debt burden from $800MM to $300MM, and she transfers 100% ofthe HCP's ownership to its lenders. She values the 100% ownership stake at $300MM,bringing HCP's total EV to $600MM.


AFTERWORD

CHAPTER 15


YOU'VE ONLY JUST BEGUN...

If you are still reading at this point you should congratulate yourself on mastering thefundamentals of the accounting language, and for getting a glimpse of how useful the languagecan be. You should be happy that your knowledge of accounting is better than almost everyoneelse's (if you consider the entire population of the world), including that of many Wall Streetanalysts.

As scintillating as accounting is in its own right 1, it gets even more exciting when applied toproblems in corporate and public finance. We've seen examples of this in our ratio analysisstudies and our analysis of Fannie Mae's collapse. To learn more great applications ofaccounting you need to know more about Finance. To get started, I recommend (in self-servingorder):

Introduction to Business Finance. Anthony Webster. Corporate Finance. Ivo Welch. Analysis for Financial Management. Robert Higgens. Fundamentals of Corporate Finance. Richard Brealey, Stewart Myers and Alan Marcus.

As you learn finance, you will find that more accounting knowledge is helpful, and in some casesnecessary (as with, for example, the study of tax-deferred assets and LIFO/FIFO inventory). Toparaphrase Wallis Simpson, the former Duchess of Windsor, 'you can't be too rich, too thin, orknow too much accounting.' With this in mind, here are a couple of suggestions for furtherstudy:

Financial Accounting. Larry Walther. Intermediate Accounting. Donald Kieso, Jerry Weygandt, and Terry Warfield.

For anyone considering a career in accounting or finance, its extremely important to keepcurrent. To achieve this, I suggest reading every accounting, finance and economics article youcan find in:

The Wall Street Journal. The Financial Times. Barrons. The Economist.

I also strongly suggest listening to Bloomberg radio, which provides more in-depth interviewswith Nobel Laureates, brilliant economists, and world-class investors than any other media outletI've found.

Finally, I hope that you've learned some useful and interesting things in this text. Feel free tosend comments and queries – good, bad and ugly – to me at [email protected].

1 Just kidding.

CHAPTER15–AFTERWORD PAGE2Licensed to: Vikas Arun - 3060 W Lake Sammamish Pkwy NE Redmond, WA 98052 - [email protected]

ABOUT THE AUTHOR

Anthony Webster is a Lecturer in Finance at Columbia University’s School of Engineering andApplied Science, where he teaches Introduction to Accounting and Finance, Real EstateFinance, and Decision Models and Applications. He has also taught Decision Models atColumbia’s Graduate Business School and the Berkeley-Columbia joint MBA program.Columbia’s students have awarded Mr. Webster their highest accolade -- “Golden NuggetProfessor” status – at their instructor-evaluation website, CULPA.info.

In 2002, Mr. Webster founded West End Advisors, LLC, a registered investment advisory firmthat provides investment management and financial planning services to individuals andinstitutional investors. He is currently president and senior portfolio manager at the company.

Mr. Webster is the author of two textbooks: Introduction to Accounting and Introduction toBusiness Finance. He has also written books on technology and construction economics,published extensively in leading technology journals, and served on the boards of high-growthcompanies and leading technical publications.

Mr. Webster holds an MBA from Columbia University's Business School, an MS in EngineeringMechanics from Columbia University’s Engineering School, and a BS in Applied Science inEngineering from Rutgers University (summa cum laude). He is a registered investment advisor(CRD 4619426).


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