Beruflich Dokumente
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WEISS
THE BUSINESS
EXPERT PRESS A Guide to Understanding Financial and Auditing Collection
DIGITAL LIBRARIES Statements Mark S. Bettner and Michael P. Coyne, Editors
Accounting
BUSINESS STUDENTS Accounting is an economic information system, and can
Curriculum-oriented, born- be thought of as the language of business. Accounting prin-
digital books for advanced ciples cannot be discovered; they are created, developed, or
business students, written decreed and are supported or justified by intuition, author-
for Fun
by academic thought ity, and acceptability. Managers have alternatives in their
leaders who translate real- accounting choices; the decisions are political, and trade-
world business experience offs will be made.
and Profit
into course readings and Accounting information provides individuals, both
reference materials for inside and outside a firm, with a starting point to
students expecting to tackle understand and evaluate the key drivers of a firm, its
financial position, and performance. If you are manag-
management and leadership
challenges during their
professional careers.
ing a firm, investing in a firm, lending to a firm, or even
working for a firm, you should be able to read the firm’s
financial statements and ask questions based on those
A Guide to
Lawrence A. Weiss
Accounting For Fun and Profit: A Guide to Understanding Financial
Statements
Copyright © Lawrence A. Weiss, 2016
10 9 8 7 6 5 4 3 2 1
Keywords
Accounting, economic drivers of a firm, financial statements, financial
analysis
Contents
Acknowledgments....................................................................................xi
Preface������������������������������������������������������������������������������������������������xiii
Chapter 1 Introduction......................................................................1
Chapter 2 Accounting is Not Economic Reality................................15
Chapter 3 The Accounting Process...................................................27
Chapter 4 Accrual Accounting..........................................................49
Chapter 5 Current Assets..................................................................59
Chapter 6 Long-Term Assets.............................................................87
Chapter 7 Current Liabilities............................................................97
Chapter 8 The Time Value of Money: Discounting
and Net Present Values...................................................111
Chapter 9 Long-Term Debt............................................................127
Chapter 10 Owners’ Equity..............................................................143
Chapter 11 Cash is King...................................................................153
Chapter 12 Financial Statement Analysis..........................................177
Index..................................................................................................189
Acknowledgments
I am grateful to Bridgette Hayes and Stephanie Landers, who corrected
my many editorial mistakes and helped make my prose easier to read.
I would also like to thank Michael Duh for helping to ensure the numbers
are consistent.
A special thanks is also owed to Prof. Mark Bettner for his editorial
comments as well as Scott Isenberg and the team at Business Expert Press.
Finally, I would like to thank my former teachers for setting me on
my academic path and all my former students who have made my career
such a pleasure.
Preface
If you were building a house, would you hire an architect, give her some
money and say, “Build me a house?” If you did, the house might end up on
the front cover of an architectural magazine, but it might not be a house
you would want to live in. I suggest you might benefit from learning a bit
about architecture before building a house so that you could work with
the architect to build the house you want to live in. Similarly, if a surgeon
(who is paid to cut people open, who enjoys cutting people open, and
who honestly believes she can best cure people by cutting them open)
suggests an operation, you would be smart to learn about your illness and
get a second opinion before having the surgery.
Accounting is no different, and it is much too important to be left to
the accountants. If there is one message you should take away from this
book, it is NEVER TRUST AN ACCOUNTANT! This may seem a bit
harsh, but why would you trust an accountant any more than an architect,
doctor, or other professional? A healthy dose of skepticism is a good thing.
Any time you hire a professional, it is best to have a basic understanding
of what the professional does so you can tell the professional what you
want them to do. If you have a medical condition that might require sur-
gery, know enough about your condition to determine whether surgery
is the right course of action and, if it is, to find the best surgeon for you
(not a good idea to try doing surgery on yourself!). Likewise, if you are
managing a firm, investing in a firm, lending to a firm, or even working
for a firm, you should be able to read the firm’s financial statements and
ask questions based on those statements.
This book explains the fundamentals of financial statements. Many
accountants would benefit from reading this book as it may help them
better understand why they are doing what they do, and improve their
ability to explain accounting to others. However, the book is not designed
for accountants. It is designed and meant for those who use and provide
accounting information (i.e., those who hire accountants).
xiv PREFACE
Introduction
1
The government actually gets two sets of financial data. One is the tax information
which all firms must provide to the Internal Revenue Service (IRS) and is not publicly
available. The other is the public financial information that the firm provides to the
Security and Exchange Commission (SEC) which then posts it on an electronic site
called EDGAR. See www.sec.gov/edgar.shtml
2
The vast majority of firms are private, and most of these are owner managed (mean-
ing the firms’ owners are also the managers). However, there are some very large firms
which are private. For example, Mars Corporation (the large confectionary firm with
brands such as M&M’s) is a private company and its accounting information is not
available to the general public.
INTRODUCTION
3
What is this report about? What is it meant to tell the users? It is designed
to give the users identified above information about the firm’s economic
resources, how it obtained those resources, who has claims on the re-
sources, what the firm has done with those resources, and how they have
changed over time. It is designed and meant for users who have some
understanding of basic business, economics, and accounting.
How are these various groups going to use this information? The informa-
tion should be used as a starting point in trying to estimate the timing,
likelihood, and amount of future cash flows. Why? So they can assess a
firm’s financial health and make better informed decisions (i.e., invest in
the firm, sell to the firm, lend to the firm, buy from the firm, and so on).
Okay, so if senior management is producing this information for a va-
riety of users, it means management is basically providing outsiders with
information about the senior management’s activities. Is that right? Yes,
it is like a student (as opposed to a teacher) producing the report card on
how well she did. Are there any checks to make sure what management says is
true? Actually, there are not many checks we can use for this. A ccounting
has limitations; it is not, in any sense of the word, trustworthy (more on
this in Chapter 2) and it provides limited supervision of senior manage-
ment. This is why it is critical for anyone using the information in finan-
cial statements to understand how the information is prepared.
Consider, if you were senior management, what would you want to say?
Well, that depends on whom your message is for.
What does senior management normally tell the owners? It is not uncom-
mon for them to report, “I am great. You could not have a better manager.
It is true we lost a lot of money this year, but anyone else would have lost
much more. You are lucky to have us, and there is no question you should
keep us as your senior management.” Normally, management wants to
keep their jobs, and they therefore tell the owners they are doing a good,
if not great, job. However, “normally” does not mean always.
What if senior management itself wants to buy the firm from the
non-management owners? Imagine you are managing a firm you inherited
from your parents. You are working hard and doing your best, but you
do not own the firm outright. You have some siblings who also own part
of the firm, and they do not help at all. They do not pull their fair share,
yet they still demand money from the firm. Because of this, you want to
4 ACCOUNTING FOR FUN AND PROFIT
buy them out. What would you tell them? You could say the firm is doing
great. Or you could say that the firm is barely making it and that while it
is really worth next to nothing, you still want to buy it from them and will
pay them some minor amount for their shares. When reading a financial
statement, you need to know not just to whom management is talking to,
but also what senior management’s bias is. Does senior management want
to make the firm look good or bad? It depends on their bias.
What does management normally want to tell bankers and the people or
companies who sell goods and services to the firm? Typically, management
wants to tell these readers not to worry because the firm will pay what it
owes (i.e., repay loans to the banks or pay suppliers for services rendered
or goods provided).
What does management want to tell the firm’s employees? We are doing
okay but not great, so the firm is unable to give raises this year, but em-
ployees’ jobs are secure and they do not need to look for other ones. Note
that we have a potential conflict here. Management may want to tell the
owners they are doing great, but tell the employees the firm is doing okay.
How about the customers? What does management want to tell them?
Again, management wants to tell them that the firm is doing okay, that
it will be around to supply them next year, but that it is not doing well
enough to give any discounts.
What about the government? Well, the primary governmental entity
looking at firm’s financial information is the Internal Revenue Service
(IRS). To this group, management probably wants to show minimal
profits saying that it does not have much to give to the government this
year. Maybe in a few years when the firm is doing better, the government
can ask for something.
Notice that what management wants to tell the government is pretty
much the exact opposite of what they normally want to tell the firm’s own-
ers. The good news for management today is that in most countries, firms
are allowed to produce two sets of financial statements: one for the govern-
ment (which is private and intended to be read only by the government’s
taxing authorities) and another for everyone else. So to some extent, man-
agement can plead poverty to the government, while telling others they
are doing well. It may seem hard to believe that there are two sets of finan-
cial statement reporting about the same firm’s performance in the same
INTRODUCTION 5
(A) (B)
(C)
They are for the wine and spirits firm Pernod Ricard whose 37
premium brands include Absolut, Chivas, Glenlivet, G.H. Mumm
Champagne, and Kahlua among many others (the reports shown are for
the years ending 2006, 2010, and 2015). I am not really sure how they
relate to the financials, but clearly they have an artistic bend.
By contrast, the report covers in Exhibit 1.2, for Boeing, reveals its
products by showing them on the covers. Boeing is saying “this is who we
are and what we do.”
Most firms no longer have fancy covers. They simply have the in-
formation required by the government (see www.sec.gov/edgar.shtml)
and maybe the firm’s logo. Exhibit 1.3 shows the cover for Apple Inc.
The covers of annual reports tell you something about the firms that
published them. It is like getting dressed in the morning: What you wear
tells the world not only something about you but also something about
what you want the world to think about you.
And that is what the annual report is meant to do. It is senior manage-
ment telling the world something about the firm and what senior man-
agement wants the world to think about the firm.
So, let us open the cover and take a look at what is inside.
8 ACCOUNTING FOR FUN AND PROFIT
3
There is also sometimes a Statement of Changes in Retained Earnings (which is fairly
straight forward), a Statement of Changes in Equity (which can be more complex),
and a Comprehensive Income Statement (which includes all components of net in-
come/loss and other comprehensive income/loss).
INTRODUCTION
9
2002) has also done a great deal to increase auditor independence both
with increased oversight (and the creation of the Public Company Ac-
counting Oversight Board) and by limiting a uditor conflicts of interest
(e.g., the nature and extent of non-audit work done by auditors has been
greatly reduced).
So, if a firm has a good audit report can the numbers be trusted? NO!
ABSOLUTELY NOT! The auditor only expresses an “opinion” on the
“fairness” of the financial statements.4 First, the auditor is supposed to as-
sess whether the statements reasonably portray the underlying economics
within the accounting framework. However, reasonableness or fairness is
subject to interpretation, often a court of law’s interpretation. Users of
annual reports should interpret an auditor saying the numbers are rea-
sonable as the auditor saying they are close enough that she is not overly
worried about being sued. Second, the auditor does not check everything
because that would be much too time consuming, which would delay the
annual reports and make the information they contain less useful, and
would also be prohibitively expensive. Third, it is possible for the auditor
to make a good faith effort, do her job responsibly and professionally, and
still fail to discover a major error or fraud. Finally, if the auditor feels the
statements are not reasonable, she will probably enter into a negotiation
with management to change the numbers prior to publication to avoid
having to release a negative audit report.
Does that mean the audit report is basically useless? Not at all. In fact, the
report can be quite informative and useful, especially as a starting point.
Let me explain by describing the various types of audit reports and what
each means.
The first and most common is called an unqualified or clean report.
Here the auditor says he was able to do his work, and that the statements
appear reasonable and in conformity with generally accepted accounting
principles (GAAP) applied consistently over time, the auditor did not
find any material misstatements and there is no evidence suggesting that
4
In some countries, this opinion is set up as certifying the statements are true and
correct. Unfortunately, this is far from what is really done by the audit.
INTRODUCTION
11
the firm is not a viable going concern.5 This is what you should expect,
and you would then go into the statements and notes with a normal de-
gree of skepticism (i.e., caveat emptor).
The second and less common is called a qualified report. Here the
auditor notes there is something that the reader should know. Although
the auditor finds the numbers are reasonable overall, there was something
that the auditor could not examine or determine. If the auditor was hired
after the start of the year, this means the auditor would not have been
able to check last year’s number herself at the end of last year. The a uditor
would point this out and note she is relying on the previous auditor. This
begs the question: Why did the firm change auditors? 6 A positive explana-
tion is the firm was growing and the prior auditor was too small to con-
tinue auditing the growing firm. Investors and creditors may appreciate
that the new auditor is larger, hopefully has more expertise, and with its
increased size should be able to pay out a larger sum in the event of a
lawsuit. A change may also occur when one firm acquires another firm
of equal or greater size and the auditor of the acquired firm becomes the
auditor of the combined firm. There could also have been a change for
certain expertise. The financial statement user should carefully consider
whether the change in auditor was for a legitimate reason or whether the
change occurred because the prior auditor was unwilling to express a posi-
tive opinion on the statements.
The auditor may note that the statements appear reasonable overall but
that there is an overriding issue which could not be determined and could
alter the economics of the firm. For example, the firm may be subject to a
lawsuit that the auditor cannot determine if the firm is likely to win or lose,
and the amount is large enough to potentially alter the firm’s financials.
5
GAAP refers to the guidelines (rules and practices). In the U.S., they are set out by
the Financial Accounting Standards Board (FASB), whereas many other countries fol-
low those set out by the International Financial Standards Board whose guidelines are
referred to as International Financial Reporting Standards (IFRS).
6
There is a movement to force a change of auditors every few years, but the change is
in fact very expensive as auditors develop expertise with their clients. Most financial
institutions, which are considered critical to the economy, require periodic changes
in auditors.
12 ACCOUNTING FOR FUN AND PROFIT
The auditor may also note that the statements appear to be reason-
able overall but that there has been a major change in an accounting
method. As will be discussed in detail in the coming chapters, firms have
many choices over accounting policies and these choices alter the final
numbers. Changing policies is allowed, but in the year of the change,
numbers must be presented using both the old and the new method and
the annual report must explain the reason for the change. Some changes
are managerial choices, others are dictated by the government. Regardless
of whether the firm made the change voluntarily or after being forced by
the government, major policy changes are considered so important that
they will be noted in the auditors’ report.
The third and fairly rare type of audit report is called a disclaimer or
denial of opinion. In this case the auditor notes that he was unable to
perform his work and cannot express an opinion on the financial state-
ments. For instance, this can occur after a fire that destroyed factory
records, or perhaps when there is a strike and the auditor cannot access
the records.
Finally, the rarest form of opinion is called an adverse opinion. In
this case, the auditor expressly notes that the statements are not reason-
able (e.g., they do not fairly reflect the firm’s economic condition). This
can occur when a firm is in financial distress and likely to be liquidated
(when a firm is not considered a going concern all the numbers must be
at liquidation value), or if the auditor fundamentally disagrees with the
firm’s financial presentation. The latter is very rare because either (a) the
auditor and firm will negotiate some changes in the numbers to enable
the auditor to express at least a qualified opinion, (b) the auditor will be
replaced, or (c) the opinion will simply not be issued.7
7
For example, firms entering bankruptcy often do not issue timely financial statements
and thus there is no opinion.
INTRODUCTION
13
the reader at the start. Next the reader should examine the Notes to the
Financial Statements, as they put the statements into context. The state-
ments themselves should be read next. All the puffery and the CEO’s
letter at the front can be examined last. At least, this is how your author
reads an annual report.
8
I have tried to make this book fun while also paying attention to the details.
CHAPTER 2
If you press the accountant further, you will be told about the com-
ponents of the Balance Sheet and how it is produced (with a high chance
you will also be told all about the use of Debits, which means to the left,
and Credits, which means to the right—more on this in Chapter 3). The
accountant will say that if a Balance Sheet does not balance, it means a
mistake has been made. While true, this view misses what the Balance
Sheet is really about.
The Balance Sheet must balance because on one side it reflects the re-
sources that a firm owns and controls and that will provide the firm with
future cash flows (the Assets), and on the other side, how those resources
1
This chapter is also an appendix in Asquith and Weiss, Lessons in Finance © 2016.
Reprinted with permission.
16 ACCOUNTING FOR FUN AND PROFIT
are financed (the Liabilities and Equity). Each side is measured separately,
and the two sides must balance. If they are not equal, it means a mistake
has been made, which must then be found and corrected (if they are
equal, however, it does not mean the Balance Sheet is free of mistakes). A
Balance Sheet is seen in Exhibit 2.1 using a large T with the Assets on the
left and the Liabilities and Equity on the right (again the details will be
discussed in the coming chapters).
Thus, the Balance Sheet is an algebraic equation. However, the truth
is that accounting is closer to an art, or a language (the language of busi-
ness), than a science. The accounting numbers present one of many pic-
tures of the underlying economics of a firm—but there is no single truth
to present. Why? Because accounting rules and practices provide manag-
ers with discretion over how they present the economic reality of a firm.
Let us use an example to illustrate the many different accounting
“truths.” Consider a simple business venture: selling T-shirts. For sim-
plicity, the owner/investor puts in $36 (meaning both the firm’s cash and
the owner’s equity account increased by $36). Over time, the owner pur-
chases three identical T-shirts for $10, $12, and $14, meaning a total of
$36 from cash is spent and T-shirt inventory increases by $36. Note, this
example involves a change in purchase prices. It does not really matter
why the price changes (inflation, market conditions, and so on). Since,
as stated, the T-shirts are identical, a customer will not care which one
he is given. Before anything has been sold, the Balance Sheet will bal-
ance with $36 in T-shirt inventory and $36 in owner’s equity as shown
in Exhibit 2.2.
Exhibit 2.1
A simplified Balance Sheet
Assets: Liabilities:
Cash Payables (owed to suppliers)
Receivables (owed to the firm) Borrowed funds
Inventory
Other short-term resources Equity:
Property, plant, and equipment Capital received from owners
Other long-term resources Retained earnings (profits earned and kept)
Accounting is Not Economic Reality 17
Exhibit 2.2
The Balance Sheet before any sales
Assets: Liabilities:
T-shirt #1 $10 Amount borrowed $ 0
T-shirt #2 $12
T-shirt #3 $14 Equity:
Capital from owners $36
Total $36 Total $36
Now assume the business sells one T-shirt for $20. How much profit
has the business made by selling one T-shirt? Write down your answer and
then read the possible accounting choices below.
There are five possible methods to answer this question:
The first three are traditional accounting methods based on how the
firm decides to value “cost” the dollar amount of the one T-shirt sold,
which is then subtracted from the selling price. If the firm chooses to do
so in the same order they were purchased, then they would be costing
the oldest unit first. This method is called “first-in first-out” (FIFO) and
would result in the firm having a profit of $10 ($20 in revenue − $10 in
cost). Note that this leaves the most recently purchased T-shirts (the last
two T-shirts) on the Balance Sheet as assets with a value of $26 as shown
in Exhibit 2.3.
It is also possible to report the inventory by computing an average
cost for the three T-shirts ($36/3 = $12). This method is called “average”
(AVG) and produces a profit of $8 ($20 in revenue − $12 in cost). Note
that this will value the two remaining T-shirts at $12 each for a total of
$24 in inventory as shown in Exhibit 2.4.
18 ACCOUNTING FOR FUN AND PROFIT
Exhibit 2.3
First-In First-Out
Assets: Liabilities:
Cash $20 Amount borrowed $ 0
T-shirt #2 $12
T-shirt #3 $14 Equity:
Capital from owners $36
Profit $10
Total $46 Total $46
Exhibit 2.4
Average
Assets: Liabilities:
Cash $20 Amount borrowed $ 0
2 T-shirts @ $12 = $24
Equity:
Capital from owners $36
Profit $8
Total $44 Total $44
A third option is to cost the unit of inventory sold by using the most
recent purchase price. This method is called “last-in first-out” (LIFO) and
it produces a profit of $6 ($20 in revenue − $14 in cost). Note that this
leaves the earliest purchased T-shirts (the first two) in the Balance Sheet
as assets with a value of $22 (the first at $10, the second at $12) as shown
in Exhibit 2.5.
Thus, three different methods (FIFO, AVG, and LIFO), all of which
are correct, results in three different profit amounts and three different
Balance Sheets.
An argument in favor of FIFO is that the two units of unsold inven-
tory on the Balance Sheet would be valued at $26 ($12 + $14), which
is probably closer to a replacement cost of $28 (assuming prices have
Accounting is Not Economic Reality 19
Exhibit 2.5
Last-In First-Out
Assets: Liabilities:
Cash $20 Amount borrowed $ 0
T-shirt #1 $10
T-shirt #2 $12 Equity:
Capital from owners $36
Profit $6
Total $42 Total $42
increased to $14, replacing the two units would probably mean paying
the last purchase price of $14 for each one). In contrast, the inventory
value computed under LIFO is much lower than the potential replace-
ment cost: LIFO would value the remaining inventory at $22 ($10 +
$12). Thus, by using FIFO and using the value of (costing) the oldest unit
first, the Balance Sheet is more reflective of the current underlying value
(i.e., replacement cost) of inventory. The inventory number under FIFO
is probably more relevant, in terms of the Balance Sheet, than the number
under LIFO.
So why is FIFO not mandated for all financial statement disclosures? The
reason lies in the fact that firms’ equity values are not based strictly on the
numbers on a Balance Sheet. Most firms are valued based on their ability
to generate profits in the future. A key objective in financial reporting is
to provide outsiders with an ability to estimate the future cash flows of a
firm, and this is done by starting with an examination of the accounting
profits (we predict the future by starting with the past). For this, the out-
siders use not only the Balance Sheet but also the Income Statement and
the Statement of Cash Flows (all coming attractions).
Although FIFO may provide a more relevant valuation of inventory
on the Balance Sheet, the profit generated using FIFO is $10 ($20 in
revenue less $10 representing the FIFO cost of the T-shirt that was sold).
The profit generated using LIFO is $6 ($20 in revenue less $14 represent-
ing the LIFO cost of the T-shirt that was sold). Which of these two profit
numbers is a better predictor of future profits and cash flows? If the selling
20 ACCOUNTING FOR FUN AND PROFIT
price remains at $20 and the purchase of new T-shirts stays at $14, then
the $6 computed under LIFO is a better estimate of expected profits going
forward. The $4 difference in profits ($10 − $6) will eventually be realized
when the firm sells off its inventory. The extra profit on the first and sec-
ond T-shirts, for which the firm paid $10 and $12 is not sustainable, and
thus LIFO may provide a better estimate of future profits and cash flows.
The average method is a compromise between the two.
Why not simply number the three T-shirts and cost the one which is actu-
ally sold? This is a valid method called specific identification and is used
in high-value products where customers choose the specific product sold
(e.g., automobiles). However, in the example being given, the T-shirts are
of low value and identical. Costing the actual T-shirt sold would allow
management to choose the profit they will report by choosing which
T-shirt they give the customer (the customer would not care, as they
are identical). A key goal of accounting is to set up a process preventing
management from simply choosing the profit it reports to outsiders.
It is true that by being able to choose the accounting method to use—
FIFO, LIFO, and AVG—management can also alter a firm’s profit. How-
ever, because firms must disclose their accounting choice, an outsider can
interpret the profit number accordingly (and/or adjust it to reflect an
alternative choice).2
These three traditional accounting methods—FIFO, LIFO, and
AVG—demonstrate the trade-off being made between focusing on a Bal-
ance Sheet and wanting those values closer to economic reality (i.e., what
the assets are worth and how they were financed) or focusing on an In-
come Statement (the difference in selling price and costs, used to estimate
future cash flows). But there are two other possible methods to compute
the profit made by this simplified business venture.
Another approach is to focus on cash. As we will see later when we
discuss cash flows, reality is cash (or alternatively “Cash is King”). How
much cash came in, and how much cash went out? Using cash accounting,
2
Firms are allowed to change their accounting choice. However, they must state the
reason for the change and in the year of the change provide information using both
the old and new accounting methods.
Accounting is Not Economic Reality 21
Exhibit 2.6
Cash basis of accounting
Assets: Liabilities:
Cash $20 Amount borrowed $ 0
Equity:
Capital from owners $36
Loss ($16)
Total $20 Total $20
there is only one asset category: cash.3 Costs are incurred when cash is
paid and revenue occurs when cash is received. Thus, if the only asset
recorded is cash (which is what cash accounting does), then the firm will
have a loss of $16 after the sale of one T-shirt (the initial $36 outlay plus
the $20 from the first sale) as shown in Exhibit 2.6.
The benefit of the cash basis of accounting is that it reflects one ele-
ment of reality: the actual flow of cash in and out of an organization. The
limitation of this basis of accounting is that it fails to value the remaining
inventory or provide any ability to predict future cash flows.
Finally, another option is an economic concept of accounting called
fair value reporting. This approach values the remaining T-shirts not at
their cost but at an estimate of their market value. The T-shirts would be
valued at their market value, the price established by the last sale ($20
each).4 The firm’s profit is computed as the difference in value from the
start to the end of the year as shown in Exhibit 2.7.
Thus, the firm began with an economic value of $36 (the cash in-
vested by the owners) and ended with an economic value of $60 ($20
3
Cash accounting (in contrast to the more commonly used accrual accounting) is
often used by farmers, fishermen, and some small businesses. It is also sometimes used
for tax purposes.
4
Other profit numbers are possible. For example, using the last purchase price of $14
instead of the most recent selling price of $20 to value the two units of ending inven-
tory, which would yield a final Balance Sheet of $48 ($20 cash and 2 × $14 = $28 in
inventory) and a profit of $12 (a $36 starting value vs. $48 ending value).
22 ACCOUNTING FOR FUN AND PROFIT
Exhibit 2.7
Fair value
Assets: Liabilities:
Cash $20 Amount borrowed $ 0
2 T-shirts at $20 = $40
Equity:
Capital from owners $36
Profit $24
Total $60 Total $60
cash and T-shirt inventory valued at $40). The difference between the
opening ($36) and closing firm value ($60) is the profit, real, and po-
tential, of $24. Fair value accounting reflects the fact that if we were to
sell our T-shirt business to someone else, with assets of $20 cash and two
T-shirts worth $20 each, we would be looking for a price of $60.
Fair value accounting attempts to overcome an element not corrected
by the other accounting methods: management’s discretion over the ac-
counting process. One benefit of fair value accounting is that the value
will be the same regardless of how many units are sold or in what order.
The problem with fair value accounting is that it still provides manage-
ment with discretion to influence the process by choosing how to value
the unsold inventory. The true economic value of the inventory (or what-
ever is being valued) is the relevant (i.e., useful to outsiders) number.
However, if there is no active liquid market for the item being valued,
then a management-determined number, which may not be objective,
must be used.5
Note: The choice of how to cost the inventory (FIFO, LIFO, AVG,
and so on) or of whether to use cash accounting or fair value is not re-
quired if the accounting is only done after all three T-shirts are sold. If
firms only did their accounting when the business was being liquidated,
5
A liquid market is one where assets can be sold quickly at a fair price.
Accounting is Not Economic Reality 23
all these accounting choices would give the same results.6 Thus, it is only
because we do accounting every year (or month or quarter) that we are
required to make these choices.
6
Luca Pacioli, the Venetian monk who first wrote down our modern system of ac-
counting, did so for Venetian merchants accounting for shipping expeditions. Goods
were acquired, a boat and sailors were hired. The boat sailed away, goods were traded,
the boat returned, the goods were sold. Then, the profits were distributed. Account-
ing for this type of expedition did not require the timing assumptions. Profits were
not computed per quarter or per year. The profits were computed only at the end of
the enterprise.
APPENDIX 2A
were misleading. He said he knew what he was doing was wrong. But he
rationalized those actions in his mind at the time because the result was
higher leverage, a higher return on equity, and a higher stock price. Fur-
ther, he convinced himself that his actions were acceptable because they
had been signed off by the firm’s lawyers, accountants, and board and
were disclosed in the financial reports. He told himself his actions were
systemic, it is the way the game is played. All who cared to know knew.
As Fastow rhetorically asked my students:
“If the internal and external auditors and lawyers sign off on it, does that
make it okay?”
The problem is that attorneys, accountants, managers, boards, and
bankers are not gatekeepers; rather, they are there to help businesses ex-
ecute deals. They are enablers. In the case of Enron, these outside advisers
played an active role in structuring and disclosing the deals, and the board
approved them, but managers were still responsible for their own actions.
Thus, technically following the rules as interpreted by these advisers, even
if theirs is the best expertise money can buy, does not make a given action
“right.” Fastow emphasized that enablers are not an excuse: Each indi-
vidual is his or her own and only gatekeeper.
Fastow suggested that to avoid falling into an ethical trap he should
have asked himself the right questions: Am I only following the rules or am
I following the principles? If this were a private partnership, would I do the
same deal?
Regulation has not prevented fraud. In fact, it may have exacerbated
the problem. Enron viewed the complexity or ambiguity of rules as an
opportunity to game the system.
Compare Enron’s deals with the structured finance innovations
we’ve seen since the passage of the Sarbanes–Oxley Act: Enron’s pre-
pays (circular commodity sales which moved debt off the Balance Sheet
and generated funds flow) look very similar to Lehman’s Repo 105s
(short-term loans secured with a transfer of securities treated as a sale
of securities). The mispriced investments and derivatives at Enron look
similar to mortgage-backed securities at banks or companies with a dis-
proportionate amount of Level 3 fair value assets (illiquid assets with
highly subjective estimated values). Enron’s $35 billion in off-balance
sheet debt looks puny compared to the $1.1 trillion of off-balance sheet
26 APPENDIX
debt at Citi in 2007. Enron did not pay income taxes in four of its last
five years, and GE pays little today. Banks are now engaging in “capital
relief ” deals that inflate regulatory capital in advance of the new Basel
standards. Are these deals true risk transfers or are they cosmetic?
If regulation is not the answer, then how can corporations and society pre-
vent fraud in the future? Fastow said we can begin by understanding that
structured finance is like steroids: A little can cure many illnesses, but a lot
can destroy your organs. Its use needs to be limited, and investments in
firms that use structured vehicles without a clear business reason should
be avoided. Mark-to-market accounting can lead to more transparent fi-
nancial statements but, if abused, can put a company in a hole that it
can’t climb out of. The market must value transparency. Companies with
the fairest disclosures must be rewarded, not placed at a disadvantage as is
now the case. Finally, executives must ask whether a transaction is consis-
tent with the principle and not just the rules. Are they doing it for window
dressing or for valid business purposes?
It is critical for analysts, directors, and managers to maintain a cer-
tain sense of humility and to understand how human nature, competitive
pressures, and a lack of clear guidelines can lead to potentially disastrous
choices. And it is not just corporations that engage in these practices. Yes,
Enron hid debt in derivatives. So did Greece.
CHAPTER 3
Would a potential investor care about how much Apple Inc. has in cash in each
of its stores, bank accounts, and factories or would they just want to know the
total cash the firm has? The investor would mostly care about the total cash
amount. Additionally, providing information on all of Apple’s accounts
would overwhelm most outsiders (e.g., 10,000 cash accounts translates to
250 pages at 40 lines a page). Second, it is not cost effective for an orga-
nization to provide all its detailed accounting information to the general
public. Third, most organizations do not want to reveal specific details of
their operations to their competitors, who are able to access any informa-
tion made available to the general public. Thus, although Apple needs to
keep track of each individual cash account, outsiders are only provided
with a total amount and probably do not need more than that.
If organizations do not provide all of their accounting information, what
information do they provide? As explained in more detail below, public or-
ganizations provide certain financial statements along with explanations
(notes) detailing their accounting choices, estimates, and assumptions.
Assets are resources the firm owns or controls that will provide some
future economic benefit to the firm based on a past transaction or event.
(It may be useful to read the prior sentence a few times.) Assets are sepa-
rated into current assets (those which will be used or converted to cash
usually within 1 year) and long-term assets.
1
The Balance Sheet’s name is usually thought to derive from the requirement of the
left side (Assets) equal, or balance, with the right side (Liabilities and Equity). How-
ever, it can also be argued that the name derives from the listing of the ending values
or “balances” in the accounts.
The Accounting Process 29
2
Balance Sheets can be presented on two pages, with assets on the left page and liabili-
ties and owners’ equity on the right page or, as in Exhibit 3.1, on one page with the
assets on top and the liabilities and owners’ equity on the bottom.
30 ACCOUNTING FOR FUN AND PROFIT
Exhibit 3.1
T-shirt Company’s Balance Sheets
As of December 31 2016 2015
Assets:
Cash (currency on hand and in the bank) $ 25,000 $ 20,000
Receivables (funds owed to the firm by customers) $100,000 $ 80,000
Inventory (raw materials, in process and finished products) $140,000 $ 120,000
Other (items paid in advance, e.g., utilities) $ 5,000 $ 10,000
Total current assets (becomes cash or is used within 1 year) $270,000 $ 230,000
Property, plant, and equipment (land, buildings, and $350,000 $ 300,000
machinery)
Total assets (total resources the firm has to run its business) $620,000 $530,000
Liabilities and owners’ equity:
Accounts payable (amounts owed to the firm’s suppliers) $ 105,000 $ 72,000
Wages payable (amounts owed to the firm’s employees) $ 15,000 $ 5,500
Total current liabilities (to be paid within 1 year) $ 120,000 $ 77,500
Long-term debt (borrowed funds to be repaid after 1 year) $ 200,000 $ 200,000
Total liabilities (funds financed from non-owners) $ 320,000 $ 277,500
Contributed capital (funds provided by the owners) $ 220,000 $ 220,000
Retained earnings (profits earned and not given to the owners) $ 80,000 $ 32,500
Total owners’ equity $ 300,000 $ 252,500
Total liabilities and owners’ equity (must equal total assets) $620,000 $530,000
to be shortly after the busy holiday season), but many firms choose cal-
endar year-ends.
Second, note the example does indeed balance (Assets = Liabilities +
Owners’ Equity = $530,000 in 2015 and $620,000 in 2016).
Third, the amounts can change over time, but do not have to. In
the example, both long-term debt and contributed capital do not change
(they remain at $200,000 and $220,000, respectively). In this case, the
firm apparently did not raise additional long-term debt or funds from its
owners in 2016.
Finally, retained earnings increased from $32,500 to $80,000. This
means the firm earned and kept $47,500. The firm may have earned more
than $47,500 (e.g., $58,500) and given the extra (e.g., $11,000) to the
owners. More on this shortly.
The Accounting Process 31
Cash
Date Description Debit (left) Credit (right)
3
Decided by Luca Pacioli, a Venetian monk, who wrote down the modern system of
accounting over 500 years ago.
32 ACCOUNTING FOR FUN AND PROFIT
Again, to an accountant, the word debit simply means left and the
word credit simply means right. Not good or bad, not up or down, just
left and right. Let us start with an owner investing $500 in a firm by giv-
ing $500 in cash to the firm. The accounting would be treated as follows:
Cash (asset)
Date Description Debit (left) Credit (right)
2/20/2015 LW deposited funds $500
Contributed capital
Date Description Debit (left) Credit (right)
2/20/2015 LW deposited funds $500
Note, an asset (cash) increases and an owners’ equity account also in-
creases.4 The Balance Sheet balances. Next the funds are placed in the firm’s
bank account, and the following entries to the accounting records are made:
Cash (asset)
Date Description Debit (left) Credit (right)
2/20/2015 Deposit funds in bank $500
Cash-in-bank (asset)
Date Description Debit (left) Credit (right)
2/20/2015 Deposit funds in bank $500
4
The detailed accounts would include a separate owners’ equity account for each
owner.
The Accounting Process 33
a liability with your name (and note the debits equal the credits). The
bank’s records would be treated as follows:
Cash (asset)
Date Description Debit (left) Credit (right)
2/20/2015 Funds received from LW $500
Deposits (liability)
Date Description Debit (left) Credit (right)
2/20/2015 Funds owed to LW $500
mathematical sense that if assets are increased with a debit and reduced
with a credit, then liabilities and owners’ equity would be increased with
a credit and reduced with a debit. Liabilities and owners’ equity are on the
other side of the equation, so their treatment is the opposite of how assets
are treated. Remember, the idea is to catch mistakes; having total debits
equal total credits is a means to that end.
The balance of an account equals the total debits less the total credits
posted to it. If the debits exceed the credits, the account has a debit bal-
ance. If the credits exceed the debits, the account has a credit balance.
Occasionally, there is a sixth column that provides a running total of this
debit or credit balance.5
Accountants often use an abbreviated form of the account called a T
account, which looks like a T with the account name on top and then the
debits on the left side and the credits on the right side. The T account is
basically the last two columns of the formal account above.
The net debit or net credit balance is shown in a T account after draw-
ing a line under the debits and credits. For example, if total debits in a
particular account are $1.5 million and total credits are $1.2 million, the
account has debit balance of $300,000, which would be inserted in the
debit column as follows.
Cash
$1,500,000
$1,200,000
$ 300,000
An Illustration
Let us illustrate with an example. Imagine the first five transactions of a
business are as follows:
1. The owners’ give the firm $220,000 cash for their ownership inter-
est in the firm. Cash, an asset, increases by $220,000 with a debit.
Contributed capital (CC), an owners’ equity account, increases by
5
One old convention is to write debit balances with black ink and credit balances in
red ink.
The Accounting Process 35
At some point after the event (it can be soon after or much later), the
amounts are recorded or entered in the specific accounts (accountants call
doing this “posting”) as follows:
Cash
Credit
Date Description Debit (left) (right)
1/1/2015 (1) Owner investment $220,000
1/2/2015 (2) Issued debt $200,000
1/3/2015 (3) Purchased PP&E $310,000
The Accounting Process 37
Merchandise inventory
Date Description Debit (left) Credit (right)
1/8/2015 (5) Received 10,000 $60,000
T-shirts
Accounts payable
Date Description Debit (left) Credit (right)
1/8/2015 (5) Received T-shirts, $60,000
unpaid
Long-term debt
Date Description Debit (left) Credit (right)
1/2/2015 (2) Issued debt $200,000
Contributed capital
Date Description Debit (left) Credit (right)
1/1/2015 (1) Owners’ investment $220,000
Note, the above accounts are listed in the order they would ap-
pear on the Balance Sheet. This could also be done using T accounts as
follows:
Note, the ending balance in cash is a debit of 110 (the debits 220 +
200 less the credit or 310).
38 ACCOUNTING FOR FUN AND PROFIT
We can add up all the debits (220 + 200 + 60 + 310 = 790) and
they equal the total credits (310 + 60 + 200 + 220 = 790). We can
also net the debits and credits for each account and then calculate the
total that gives us: cash 110 + inventory 60 + PP&E 310 = total as-
sets = 480, compared to: accounts payable 60 + long-term debt 200 +
contributed capital 220 = total liabilities and owners’ equity = 480.
Total debits equal total credits and the Balance Sheet balances.
Today, we can instead use a spreadsheet with plusses and minuses
instead of debits and credits.6 This leaves a greater chance of making a
mistake from an accountant’s point of view but is perhaps easier to follow.
The spreadsheet would be done as follows:
+60 +60
The account totals remain the same; only the format is changed. Al-
though some may prefer spreadsheets, it remains important to at least
understand debits and credits as virtually all accountants think and talk
about accounting in this way. That said, for most of the following discus-
sion, we will use a spreadsheet with plusses and minuses.
6
Note, in a spreadsheet, all accounts are increased with a plus and decreased with a minus.
The Accounting Process 39
Exhibit 3.2
T-shirt Company’s Income Statements
For the year ended December 31 2016 2015
Revenue (units sold times price per unit) $ 500,000 $ 400,000
Cost of goods sold (units sold times cost per unit) $ 350,000 $ 300,000
Gross profit (revenue—cost of goods sold) $ 150,000 $ 100,000
Selling, general, and administrative expenses (business $ 46,000 $ 36,000
costs)
Operating profit (profits before financing charges and taxes) $ 104,000 $ 64,000
Interest expense (financing, or borrowed funds, costs) $ 14,000 $ 14,000
Profit before tax (profits after financing but before tax) $ 90,000 $ 50,000
Income tax (the government’s take, in this case 35%) $ 31,500 $ 17,500
Net profit (also called the “bottom line”) $ 58,500 $ 32,500
40 ACCOUNTING FOR FUN AND PROFIT
For example, assume 2015 is the first year of operation for the T-shirt
firm, which started in January. This means the retained earnings account at
the start of 2015 would have been $0 (the firm had no profits or losses at its
inception). From the 2015 Income Statement, we see profits of $32,500,
and the Balance Sheet retained earnings account has a year-end balance of
the same amount. This means that the firm made no distributions to the
owners in the first year. How do we know how much the firm distributed to
owners? The previous equation has four elements: an opening balance, a
profit or loss, a potential distribution to the owners, and an ending bal-
ance. With any three, you can compute the fourth using algebra. In other
words, fill in what you know and solve for what you do not know.
$0 + $32,500 − $? = $32,500
How much were dividends? They have to be $0 in order for the equa-
tion to balance. Therefore, no dividends were paid in 2015.
In 2016, the firm starts the year with an opening balance in retained
earnings of $32,500. How do you know that? Remember, all Balance Sheet
accounts are at a specific instant in time. The amount a firm has at mid-
night December 31, 2015, will be the same amount it has one second past
midnight the morning of January 1, 2016. Hence, the ending balance last
year is the opening balance this year. From the 2016 Income Statement,
we see profits of $58,500. This means retained earnings started the year at
$32,500 and increased by $58,500 bringing the total to $91,000. However,
the amount of retained earnings at the end of 2016 is only $80,000. How is
this possible? The firm must have paid the owners the difference of $11,000.
How much were dividends? To balance, they must have been $11,000.
This is one of the keys to accounting: the math has to work. In the
example, we compute dividends as the missing variable. In reality, the
The Accounting Process 41
firm would have the opening balance, the income (or loss), the dividends,
and the closing balance. If the math did not work as above ($32,500 +
$58,500 − $11,000 = $80,000), it would mean a mistake had been made
somewhere. That is how the accounting system, one of check and bal-
ances, works.
R/E = R/Eat the start of the year + Profit (or −Loss) − Dividends, and
7
There are differences in accounting and terminology based on the type of firm (i.e.,
proprietorships, partnerships, and corporations). For simplicity, the illustrations will
use the corporate form with owners’ referred to as stockholders (or shareholders).
42 ACCOUNTING FOR FUN AND PROFIT
The revenue accounts increase the right hand side of the equation. For ex-
ample, if a T-shirt is sold for $8 cash, the firm increases the cash account by $8
with a debit and the revenue account by $8 with a credit. The cash account is
on the left side of the equation, and the revenue account is on the right side of
the equation. This means revenue accounts are treated like the liabilities and
owners’ equity accounts (increased with credits and decreased with debits).
Expenses do the opposite. For example, when the T-shirt is sold, the firm has
one less T-shirt on hand. Assume the T-shirt cost $6. The firm would then
decrease its T-shirt inventory account by $6 with a credit and increase its Cost
of Goods Sold (COGS) by $6 with a debit. This means expenses are treated
like assets (increased with debits and decreased with credits).
This also explains the “as at” for Balance Sheet accounts and the “for
the period ending” for Income Statement accounts. The Balance Sheets
accounts are a running total. The Income Statement accounts are for
a specific period of time and are linked to the Balance Sheet through
retained earnings. This link occurs at the end of the accounting period
(normally a year) when the Income Statement accounts are reset to zero
(closed) with the profit or loss (the difference in the revenues and ex-
penses) entered into the retained earnings account.
At the end of the period, the Income Statement’s revenue accounts, which
would have credit balances from activities during the period, are reduced to
zero with debits. The required balancing credit is made to retained earnings,
thereby increasing the owners’ equity account on the Balance Sheet.
Next, the Income Statement’s expense accounts, which would have
debit balances, are reduced to zero with credits. The balancing debit is
made to retained earnings, thereby reducing the owners’ equity account
on the Balance Sheet.
In sum, the Balance Sheet’s retained earnings account is in-
creased when there is a profit (i.e., when revenues exceed expenses)
The Accounting Process 43
and decreased when there is a loss (i.e., when expenses exceed rev-
enues). For simplification, the process involves debiting each revenue
account, crediting each expense account, and then making one credit
(if a profit) or debit (if a loss) to retained earnings for the net difference
in the totals.
For example, imagine a firm begins the year with retained earnings
of $100,000. During the year, the firm has revenues of $60,000 and ex-
penses of $45,000. At the end of the year, before the revenue and expense
accounts are reset to zero, the account totals would show:
Retained earnings Revenue Expenses
$100,000 $60,0000 $45,000
8
Remember, the closing amount from the prior year is the opening amount this year
for all Balance Sheet accounts.
44 ACCOUNTING FOR FUN AND PROFIT
“An analogy: Most cars have two standard odometers (which shows
miles or kilometers driven): A cumulative odometer (which cannot
be reset) shows the total miles driven since the car was made. A trip
odometer (which can be reset by pushing a button) reflects the miles
driven from the last time the trip odometer was reset. For example,
assume the cumulative odometer begins the day with 7,600 miles and
the trip odometer shows 0. During the day 140 miles are driven. At the
end of the day, before the trip odometer is reset, the cumulative odom-
eter shows 7,740 miles and the trip odometer shows 140. When the
trip odometer is reset to zero the cumulative odometer is unchanged.
Now imagine an accountant had designed the odometers. Before the
trip odometer is reset, the cumulative odometer would be unchanged
at 7,600 miles and the trip odometer would show 140 miles. Then,
when the reset button is pressed, both odometers would change to
7,740 and 0. In effect, retained earnings on the Balance Sheet does not
show cumulative earnings less amounts paid to the owners until the
Income Statement accounts are reset to zero.”
6. The firm sells 10,000 T-shirts for $8 each, receiving full payment at
the time of sale.
7. The firm pays for the first 10,000 T-shirts and then orders and re-
ceives another 60,000 T-shirts for $6 each. By year-end, the firm has
paid for all but 12,000 of the T-shirts it purchased during the year.
8. During the rest of the year, the firm sells another 40,000 T-shirts for
$8 each, but now gives some customers 30 days to pay. At year-end,
the firm has been paid for 30,000 of these T-shirts but is still owed
for 10,000 of them.
9. Half way through the year, the firm decides it should get insurance.
The insurance firm charges $20,000 for a 1-year insurance policy. The
firm pays the full $20,000 on July 1, 2015.
10. The firm incurs various operating costs during the year, other than the
insurance. These other costs include a $10,000 reduction in the value
of PP&E (more on this later in the book), $2,000 for advertising,
The Accounting Process 45
and $14,000 for wages. At year-end, the firm has paid the workers
$8,500 and still owes them $5,500.
11. Interest on the debt is paid (at a rate of 7 percent per year).
12. Estimated taxes (computed at the rate of 35 percent of profit before
tax) are paid.
The entries to record each of these events are as follows:
The T-shirt Company’s Income Statement for the year ended 2015
Revenue $400,000
Cost of goods sold $300,000
Gross profit $100,000
Selling, general, and administrative $ 36,000
Earnings before interest and tax $ 64,000
Interest expense $ 14,000
Profit before tax $ 50,000
Income tax $ 17,500
Net profit $ 32,500
Accrual Accounting
The first three chapters introduced the reader to the accounting cycle,
the Balance Sheet, and the Income Statement as well as established that
accounting provides a picture of an organization but within limits and
that there is no truth in accounting. The Balance Sheet provides a start-
ing point to understand a firm’s resources and how it financed them at a
point in time. The Income Statement is meant to show not only whether
a firm made money (or not) but also how it generated the profit (or loss).
The Income Statement is also used as the first step in forecasting a firm’s
future cash flows.
This chapter illustrates the accrual method of accounting, which is
what most organizations use, where revenue is recognized when goods
or services are provided and expenses are matched to revenues. In other
words, regardless of when cash is actually received, under the accrual
method of accounting, revenue is recognized at the time of delivery. If
cash is received before the goods are provided or services rendered, the
cash account increases (since the firm has the cash), and a liability account
is also increased (the liability reflects that the firm owes the customers
goods or services). When the goods or services are then provided, the
revenue is recognized and the liability is reduced. If cash is paid at the
time of delivery, then cash increases and the revenue is recognized. If cash
is going to be paid after delivery, then at the time of delivery, the revenue
is recognized and a receivable account increases (a receivable means the
customer owes the firm money). This is not as straightforward as it may
seem, as there are some important complications.
50 ACCOUNTING FOR FUN AND PROFIT
1
There used to be an investment bank called E.F. Hutton (the firm with the same
name today is a new firm which bought the name), which had a great advertise-
ment where the announcer said, “We make our money the old-fashioned way: We
earn it!” The firm had another great advertisement where it said, “When E.F. Hutton
talks, people listen.” This may have nothing to do with accounting, but interesting
nonetheless.
2
Prior rules had many of these elements. The new rules are set to be implemented in
the U.S. as of December 15, 2017 for public companies.
Accrual Accounting 51
3
Interestingly, reasonable assurance of collection is set at 50 percent under IFRS and
75 to 80 percent in the U.S.
52 ACCOUNTING FOR FUN AND PROFIT
and 5-year storage? In this case, each separate product or service must be
valued. This can be done in many different ways. One could value the
wine at $1,200 and the storage at the remaining $50. ($1,250 − $1,200).
Another could prorate the wine as $1,250 × $1,200 / ($1,200 + $100)
and the storage at $1,250 × $100 / ($1,200 + $100). The firm’s choice
would be disclosed in the Notes to the Financial Statements.
How would a real estate developer recognize revenue? Once again, it
depends. If the developer is building homes and then selling them, rev-
enue cannot be recognized until they are sold because the price will only
be known when they are sold. However, if the developer is building the
home for a particular customer under a contract, then revenue can be
recognized as the home is being built. Here, an assumption (with justi-
fication) has to be made as to what percentage of the work is done each
period.
How should a firm that builds nuclear submarines for the government
under contract recognize revenues? Can it recognize revenue as they build the
submarine? Only if it has built submarines before and are reasonably sure
the submarine will float (submarines do have to float).4 If this is the first
submarine it has ever built, then perhaps it should wait until the subma-
rine is built and proven to work.
Finally, how would a travel agency recognize revenue? For this ex-
ample, let us go back to a travel agency in the pre-Internet era. A
bricks-and-mortar travel agency where travelers would come in or call
in, and an agent would book an airline flight. The agency would collect
money from the traveler and give it to the airline. After the flight, the air-
line would pay a commission of, for instance, 5 percent to the agency. Let
us assume, there are two flights booked this year for travel next year. One
is for $1,000 from Boston to New York in business class. This is a full fare
ticket, fully refundable or changeable. The other is for $300 from Boston
to New York in coach class. This is a nonrefundable, non-changeable,
use-it-or-lose-it ticket. The commission on the first ticket is $50. The
commission on the second ticket is $15. Can any revenue be recognized this
year or does the travel agency have to wait until next year, after the flights have
4
Submarine engineers, those who design submarines, are often in the submarine on its
maiden voyage. An example of proper incentives (design the submarine well or die).
Accrual Accounting 53
taken place? When is revenue earned? At the time the work is done, when the
ticket is booked, or when the flight is taken? For the first ticket, the client
may cancel the flight and then no commission will be paid. The second
ticket is locked in and the commission will be paid whether the customer
flies or not. Regardless, all the revenue would be recognized in the year
the tickets are booked as this is when the work was done. However, an
allowance would be made for an estimate of the percentage of refundable
tickets being canceled. This estimate would be based on past experience
and industry trends.
Thus, the travel agency recognizes revenue when the ticket is sold and
might set up some allowance for canceled flights. But how much revenue
should be recognized? Is the revenue $1,300 (with a related inventory cost of
$1,235 for a gross profit of $65) or is revenue the $65 commission? In the
pre-Internet era, revenue was $65, but in the post-Internet era, it was
sometimes $1,300, at least when Internet travel agencies were first set up.
greater growth potential, was worth 10 times revenue. The estimate of the
agency’s worth should have been 10 times the commission of $65. How-
ever, if an investor blindly used revenue without understanding what it
entails, he might make the estimate taking 10 times $1,300. When many
of these Internet travel agencies went bust, investors sued and said they
had been duped, misled by the accounting. However, it was obvious what
the agencies were doing. Investors were only misled if they accepted the
first line as revenue without thinking about what it really meant, without
looking at the numbers, and/or without having a basic idea of account-
ing. Although there is no doubt many of the Internet firms were trying
to mislead investors, the investors appear to have been quite ready to be
misled.5 Today the travel agent would be viewed as an “agent” and would
be required to show only the commissions as its revenue.
Expense Recognition
How about costs? When are the costs recognized? Accountants talk about
expenses, which they define as outflows from the firm, using up of assets,
or incurring liabilities in the process of producing revenue or carrying out
the firm’s daily operations during a period.
The concept of recording expenses in the same period as the revenues
to which they relate is a fundamental principal in accounting (and re-
ferred to as the matching principal). Expenses are not defined as cash
disbursements and can be recorded with, before, or after cash payments.
When expense recognition precedes cash collection, a liability (e.g., ac-
counts payable) is set up. When cash payment precedes expense recogni-
tion, an asset (e.g., prepaid expenses) is set up.
Expenses are recognized in one of two ways. First, there are those
expenses that can be tied or “matched” to revenues. For example, think
of the T-shirts being sold. We have a problem of how to cost the T-shirt
5
Understand that when the Internet was established and travel agencies started doing
online bookings, they said it was a new industry, a new economy, and that old ac-
counting practices did not matter. They claimed they purchased the ticket from the
airlines and sold it 2 seconds later (in fact they first obtained the order and funds, then
bought the ticket and delivered it—somehow it seems to be economically the same as
the brick-and-mortar process).
Accrual Accounting 55
that is sold, but the idea that when one T-shirt is sold, the cost of the
shirt is matched (expensed) to the revenue makes sense. T-shirts are not
expenses as the firm buys (or pays) for them from its suppliers; that is,
when T-shirts become part of the firm’s resources (cash down, inventory
up). The T-shirts are expenses when they are sold.
Similarly, the hair dresser could match the cost of hair spray and gel
to cutting hair. The real estate developer could match the cost of materials
and workers, adding them to the cost of the land, and putting it in the
same period as the revenue. The travel agency could match the cost of the
phones and workers to selling the tickets.
Second, those expenses that cannot be tied to revenues are recorded in
the period incurred. For example, advertising is expensed in the year the ad-
vertisement runs (not when paid). Why not match the advertising to the rev-
enue it helps produce? Because there is simply no reliable way to do it. In fact,
it is impossible to even know whether an advertisement will be successful in
the sense of providing any future benefits. There are many, even entertain-
ing and award winning, advertisements that failed to increase sales.6
Note that there are two ways for management to alter accounting
numbers. One is through the choice of which accounting technique, es-
timates or assumptions to use. The other is to change the underlying eco-
nomics (in other words, decide to postpone or move up certain activities).
If the firm is having a bad year and wants to increase profits, it can do so
by delaying when its advertisements run. If the advertisement is delayed
until next year, the cost is delayed until next year. Of course, this could
adversely affect next year’s sales—but that is another issue. Likewise, in
a good year, the firm could increase advertisements, thereby reducing
profits in the current year with the benefit from the advertisements in
the following year. Remember, there is no truth in accounting; you must
6
One example from the late 1980s was an award winning series of advertisements
for Isuzu automobiles. In the advertisements a salesman, called Joe Isuzu played by
the comedian David Leisure, lied about the cars. The advertisements supposedly did
increase traffic at the car dealers (and so arguably a success according to the advertis-
ing agency) but failed to increase the firm’s revenues and the cars are no longer sold in
the U.S. See https://www.youtube.com/watch?v=J5IgatESU9A (viewed January 19,
2015 at 9.30 p.m. EST).
56 ACCOUNTING FOR FUN AND PROFIT
understand the process in order to use accounting to gain insight into the
underlying economic reality.
Not all firms have a cost of goods sold (COGS). Some service firms
create a cost of services provided, but many do not, choosing instead
to simply list the various individual cost categories. All the items pre-
sented are broad categories, representing the minimum required level of
disclosure. More detailed information is always allowed: The question is
whether the firm wants to provide it. Remember, there is a cost to provide
additional information, both in its preparation and also in how it could
be used by others (competitors, governments, reporters, and so on).
Many additional details, if not included in the Income Statement it-
self (as for the Balance Sheet), will be provided in the Notes to the Finan-
cial Statements. Let us consider revenue in more detail.
A single line for revenue would mean this amount is “net” of any re-
turns and discounts. It may include a reduction for possible non-payments
(discussed more in the next chapter). Also, depending on the nature of the
firm, owners and others may want to know more about the details of the
revenue. Firms are required to provide information about major classes of
Accrual Accounting 57
Exhibit 4.1
Apple Inc. selected sales details
Net sales by operating
segment ($ millions) 2015 2014 2013
Americas 93,864 80,095 77,093
Europe 50,337 44,285 40,980
Greater China 58,715 31,853 27,016
Japan 15,706 15,314 13,782
Rest of Asia Pacific 15,093 11,248 12,039
Total 233,715 182,795 170,910
Net sales by product
($ millions) 2015 2014 2013
iPhone 155,041 101,991 91,279
iPad 23,227 30,283 31,980
Mac 25,471 24,079 21,483
Services 19,909 18,063 16,051
Other products 10,067 8,379 10,117
Total 233,715 182,795 170,910
Unit sales by product
($ Thousands) 2015 2014 2013
iPhone 231,218 169,219 150,257
iPad 54,856 67,977 71,033
Mac 20,587 18,906 16,341
Revenue is not the only item for which additional information is pro-
vided. Every category of expenses also has more information, and often
there are breakdowns of profit by product category and region (in ef-
fect mini-income statements). How much did Apple spend on research and
development? Apple spent $8.1 billion on R&D in 2015, up from $6.0
billion in 2014 and $4.5 billion in 2013. This information is provided
directly in the Income Statements. How much did Apple spend on advertis-
ing? Apple’s advertising expense was $1.8 billion in 2015, up from $1.2
billion in 2014 and $1.1 billion in 2013. This detail is found in the ad-
ditional information in the Notes to the Financial Statements.
It is also worth noting how the expenses are categorized and the vari-
ous subtotals presented on the Income Statement. First, there is a differ-
ence between the selling price and the direct cost (e.g., in Apple’s case, the
cost to produce the product sold) and it is called gross profit. It reflects
how much more a firm can sell its products for over the cost to produce
or procure them. Then, the costs to operate the firm over the period are
presented in a broad category called selling, general, and administrative
(SG&A) expenses. This gives a subtotal called operating profit comprised
of gross profit minus SG&A. It provides the profitability of the firm be-
fore financing charges and corporate income taxes. Financing charges
come next with the subtotal of profit before taxes. The expense items
end with taxes and then net income or net profit (the two terms are used
interchangeably and are also referred to as the “bottom line”).7
7
A firm is considered in the “black” if it has made a profit or in the “red” if it has a loss.
Note, the Thanksgiving Shopping Day known as Black Friday comes from the idea
that it takes until sometime in late November for a retailer to make enough to cover its
operating expenses for the year (and move from being in the red to being in the black).
CHAPTER 5
Current Assets
Cash
Apple, Alphabet (Google), Microsoft, and Exxon are the four largest U.S.
(and world) public firms and have lots of cash.2 According to their Balance
Sheets, the firms’ cash hoards (including cash, cash equivalents, and market-
able securities that they could rapidly turn into cash) are as follows:
Apple Google Microsoft Exxon
(Billions) 12/26/15 12/31/15 12/31/15 12/31/15
Cash and cash equivalents $21.1 $16.5 $7.2 $3.7
Marketable securities (short- and
184.5 56.5 107.0 0.0
long-term)
Total $205.6 $73.0 $114.2 $3.7
1
The ordering of assets differs by country. Firms in the US and Canada normally list
cash first.
2
They were the largest U.S. firms by market capitalization (the market price of a share
times the number of shares held by the public) as of January 29, 2016. Apple is
#1 (at $542.7 billion), Alphabet (Google) is #2 (at $523.6 billion), Microsoft is #3
(at $440.1 billion), and Exxon (ExxonMobil) is #4 (at $324.1 billion).
60 ACCOUNTING FOR FUN AND PROFIT
Of all the accounting numbers, cash is the one closest to its true,
underlying economic value. But how could cash represent anything but
its true underlying economic value? Actually, even cash can have slight
differences based on how it is estimated. If all the cash is in one cur-
rency (e.g., U.S. dollars), then there is no estimation required and there
should be only one number for cash. However, if a firm holds different
currencies (as all the firms above do), then the question is how to value
the foreign currency. Normally this is done using the year-end exchange
rate, but there may be more than 1 year-end exchange rate. There is the
bid (the price or rate someone is willing to pay for the currency), the
ask (the price or rate at which someone is willing to sell the currency),
and the close (the price or rate of the actual final trade). Which exchange
(market) should be used? (There are different currency exchanges.) Should
the bank commission be included? What about currencies that do not have
large active markets? Even for cash, which at first seems to be an easy
valuation situation, there may be some assumptions and estimates re-
quired. However, differences in the final number should not be very
large. Also, there are no alternative accounting choices like those we
saw in Chapter 2 for inventory (i.e., first-in first-out [FIFO] and last-in
first-out [LIFO]). Cash is a number that is normally as trustworthy as
an accounting number can be.
Cash seems pretty straightforward: It is actual currency that the firm
holds in one or several bank accounts, and at worst you will have to con-
vert cash held in foreign currencies into the currency in which you are
reporting your financial statements.
But what is a cash equivalent? It is a marketable security that the firm
could almost instantly convert to cash and something that is expected to
become cash in a very short period of time. One common example is a
U.S. government debt, money market accounts, and commercial paper
that matures within a few months of a firm’s year-end. However, dif-
ferent firms have slightly different definitions for what they include as
cash equivalents (again, the Notes to the Financial Statements must be
read). Most firms only include items that automatically become cash (i.e.,
bonds3), excluding even highly traded equities.
3
Bonds are discussed in detail in Chapter 9.
Current Assets 61
See http://articles.latimes.com/1990-04-10/news/mn-1040_1_soviet-
union (viewed on 24 November 2014 10 p.m. EST)
Marketable Securities
If there is an active market where securities (i.e., debt or equity) are actively
traded, the securities are considered “marketable.” Shares of Apple Inc. are
4
See Apple Inc. | 2015 Form 10-K | 47.
5
See Google Inc. | 2014 Form 10-K | 52.
6
As an aside, one item that should not be included as a cash equivalent would be post-
age stamps. Just for fun, try returning them to the post office and asking for a refund.
They are not easily turned into cash.
62 ACCOUNTING FOR FUN AND PROFIT
7
See: http://news.cnet.com/2100-1001-202143.html (viewed 11/24/14 10 PM EST).
8
However, the mark-to-market rule remains highly controversial. A more complete
discussion is provided in Accounting for Fun and Profit: Understanding Advanced
Topics in Accounting.
Current Assets 63
Accounts Receivable
Firms often allow customers a set period of time from when goods or ser-
vices are delivered until payment by the customer must be made. Com-
mon terms would be n/30 (net 30) or n/60 (net 60), which means the
payment is expected within 30 or 60 days, respectively. However, some-
times vendors add an incentive to induce their customers to pay earlier.
Terms such as 2/10 n/60 means the customer can take 2 percent off the
purchase price if payment is received by day 10, otherwise full payment is
expected by day 60.9 Most utilities and credit cards give consumers n/30
after that there is an interest charged for late payment.
Any amounts owed to a firm by an individual or by another firm can
be called a receivable. The bulk of these are owed by customers, and these
are called accounts receivables (A/R). We will focus exclusively on A/R,
but note that other types of receivables exist.
A firm recognizes (records) revenue when it delivers goods or provides
services, as discussed in Chapter 4.10 If payment is not made at the same
time, an A/R is set up. When the financial statements are prepared, the
remaining total unpaid receivables are listed on the Balance Sheet. Addi-
tionally, an accounting estimate is required to reflect the fact that not all
receivables will be ultimately paid. Sometimes, customers will simply not
have the ability to pay (e.g., firms enter financial distress and bankruptcy
and either pay nothing or perhaps pay some small amount, often the
9
Note, 2/10 n/60 translates to roughly an annual rate of 14 percent. With 2/10 n/60 a
customer who properly manages its cash should pay either on Day 10 or Day 60. This
means a 2 percent discount is offered for paying 50 days earlier. Because there are roughly
seven 50-day periods in a year (365 / 50), this means a firm taking the discount will earn
approximately 14 percent over the year (7 × 2%). If the customer’s cost of capital is less
than 14 percent, she should take the discount, otherwise it is better to pay on Day 60.
10
Another interesting aside is the terms of delivery. Goods are considered delivered
when they are placed on the transport if the terms are free on board (FOB) but not
until they reach the customers place of business if the terms are free to destination
(FTD). Now consider a firm loading its product onto a ship, the terms are FOB, and
the merchandise falls into the water between the dock and the ship. Are the goods
considered to have been delivered? It depends on where the crane loading the goods is
located. If the crane is on the dock, then the goods are not considered delivered to the
ship until they are on the ship. However, if the crane is on the ship, then the goods are
considered delivered as soon as the goods are lifted off the dock.
64 ACCOUNTING FOR FUN AND PROFIT
Percentage of Sales
Let us start with the Percentage of Sales (% Sales) method. How does this
method work? At year-end, management estimates the percentage of sales
that it expects it will be unable to collect (using the firm’s historical expe-
rience combined with industry and economic trends).
As an example, assume a firm has annual sales of $1 million and that,
to keep the example simple, all the sales were on credit. It is the firm’s first
year of operations, so the firm does not have any uncollected amounts
that carried over from the prior year (i.e., the opening balance of A/R is
$0). Of the $1 million in sales on credit this year, the firm has collected
$850,000 by year-end. The firm’s customers therefore together owe the
remainder of $150,000 ($1 million − $850,000 = $150,000). In other
words, the firm has an Accounts Receivable balance of $150,000 (Re-
member, the amount on the Balance Sheet for A/R is a total of numerous
customers). The formula to compute A/R is:
If the firm estimates that 2 percent of sales will never be collected, this
translates to an estimate of $20,000 (2 percent of $1 million). The firm
would show “net” A/R of $130,000 (the $150,000 less the $20,000 that
it expects not to collect). The firm would also reduce profits by $20,000
(matching the cost of the uncollected amounts, or bad debts, to the rev-
enues), thereby reducing the year-end Retained Earnings account.
Note that the firm is setting up an estimated amount for the total
amount it expects not to collect. It does not adjust the actual individual
customer accounts until it knows which specific customer(s) will not pay,
which means it does not change A/R itself. Why not? It is because the
amount on the Balance Sheet for A/R is the total of numerous customer
accounts that owe money to the firm. The firm does not yet know which
customer’s account to reduce. Thus, a new account is created called ADA
(allowance for doubtful accounts) that reflects the estimate of what will not
be collected. This is a contra or negative asset account (it is increased with
a credit and reduced with a debit) in that it is attached to an asset account
(e.g., A/R) and reduces it (as opposed to reducing the individual accounts
66 ACCOUNTING FOR FUN AND PROFIT
that make up A/R). Thus, there are many individual customer accounts to-
taling $150,000 (with a debit balance) and there is the new ADA showing
a year-end balance of $20,000 (with a credit balance). The Balance Sheet
can show both but usually just shows the net of $130,000.
Balance Sheet: Accounts receivable $150,000
Less ADA $ 20,000
Net accounts receivable $130,000
Income Statement: Bad debt expense $ 20,000
made the A/R balance will be $215,000. This is because the math of the
A/R accounts, prior to an adjustment to the ADA, is as follows:
The amount owed at the start of the second year is same as the first
year’s ending balance which is the total A/R of $150,000. Sales during the
year were $1.3 million. The firm collected $1,235,000 ($135,000 of the
amount owed from the prior year plus $1.1 million of this year’s sales).
At some point (the firm can do it at any time of its choosing), the firm
will recognize the $15,000 that it will definitely not collect and “write off”
the specific customer accounts (remember, the A/R at the end of the first
year was $150,000 and in the second year only $135,000 of that was col-
lected, leaving an actual uncollected amount of $15,000). The write-off
is done by reducing the appropriate individual customer accounts and by
reducing the ADA. For example, imagine Clown Costume Inc. (CCI),
which owed $15,000 filed for bankruptcy and is expected to be unable
to make any payments. The account of CCI is reduced (credited) by
$15,000 (with a note it is for lack of payment) and the ADA account is
reduced (debited) by $15,000.
Accounts receivable reflects the amount owed after adjusting for those
specific customers which the firm has recognized will not pay.
An aside: In the individual customer accounts, the firm will keep
track of the write-off. The account will be tagged to indicate that it has
been reduced to zero not because the customer paid but because it was
written off as uncollectible. If the customer ever returns and wants to
68 ACCOUNTING FOR FUN AND PROFIT
purchase merchandise, the firm may refuse because of the prior nonpay-
ment or may ask the customer to first repay what had been owned plus a
“finance fee.”
The ADA, as noted previously, is a contra or negative account on the
Balance Sheet. It reduces the net A/R shown on the Balance Sheet. The
formula for the ADA is as follows:
Note, the write-off lowers both the A/R and the ADA, so it has no
effect on the net A/R.
For example, prior to the write-off (and an adjustment for this year’s
bad debt expense), the A/R was $215,000 and the ADA was $20,000 for
a net of $195,000.
After the $15,000 write-off (and still before an adjustment for this
year’s bad debt expense), the A/R is $200,000 and the ADA is $5,000 for
a net of $195,000.
The estimate for bad debts expense does not affect A/R, which re-
mains at $200,000:
This means that the year 2 ending net A/R on the Balance Sheet is
$169,000 (ending A/R for year 2 of $200,000 minus the ending ADA for
year 2 of $31,000).
As can be seen previously, the ending ADA is $31,000 (or $5,000
more than the current year’s bad debt expense of $26,000). The $5,000
mistake from the overestimation of bad debt expense in year 1 is left on
the Balance Sheet, which increases the ADA from $26,000 to $31,000
and reduces the net A/R from $174,000 to $169,000.
Why not adjust the Balance Sheet to take into account the prior year’s
overestimation? It is because, as noted, the Percentage of Sales method is
an Income Statement approach. This means that this method is trying to
match revenues and costs (bad debt expense is a cost). The best estimate
of this year’s bad debts is $26,000. This is the best number to match
against this year’s revenue.
In order to adjust the Balance Sheet’s net A/R to the more accurate
value of $169,000 requires a $5,000 adjustment to both the Balance
Sheet ADA account and the Income Statement bad debts expense. This
means, in order to remove the prior year’s overestimation of $5,000
requires this year’s bad debt expense to be lowered from $26,000 to
$21,000. However, using an amount of $21,000 for year 2’s bad debt
expense does not fulfill the Percentage of Sales method’s goal of match-
ing costs (which is $26,000 in year 2) to that year’s revenues.
The firm made a mistake last year when it estimated bad debts to be
$20,000 and ultimately only $15,000 were not collected. The firm has
two choices: (1) leave the mistake on the Balance Sheet and properly
match this year’s revenues and costs with a bad debt expense of $26,000
or (2) adjust the prior year’s error on this year’s Income Statement by
reducing bad debt expense to $21,000 and thereby removing the $5,000
mistake from the Balance Sheet, which would then show the year-end
ADA as $26,000 instead of $31,000. The Percentage of Sales method
chooses option (1) and leaves the error on the Balance Sheet. Again, the
Percentage of Sales method is an Income Statement approach and focuses
on matching a year’s cost to that same year’s revenues.
Using the Percentage of Sales method, the mistakes usually average
out over time because of overestimating one year and underestimating the
next. It is possible for a firm to continually over- or underestimate, but at
Current Assets 71
some point if the ADA account becomes too large it must be reduced by
using a lower amount of bad debt expense – in that year the firm will not
match costs to revenues as well.11
The firm estimates an uncollectible rate for each time period (cat-
egory). Note that if the firm has given customers 30 days to pay, then the
$80,000 sold within the last 30 days is not yet late. The more time has
passed since the sale was made without payment, the less likely it is that
the firm will ultimately be able to collect payment and the higher the
default probability. For example:
11
The ADA can never be more than the total A/R because it cannot reduce A/R
below $0 (A/R − ADA > $0). Also, the ADA can never go below $0, it cannot in-
crease net A/R.
72 ACCOUNTING FOR FUN AND PROFIT
Probability of Estimated
Sale was made Amount default (%) ADA
0–30 days $ 80,000 4.0 $ 3,200
31–60 days $ 50,000 12.0 $ 6,000
61–90 days $ 15,000 30.0 $ 4,500
91–180 days $ 4,000 50.0 $ 2,000
Over 180 days $ 1,000 80.0 $ 800
Totals $150,000 $16,500
There are several items to note at this point. First, the estimates
under the two methods (% Sales and Aged A/R) are not likely to pro-
duce the same ending net A/R amounts. Second, aging is generally
thought to be a more accurate estimate of what will ultimately be col-
lected because it is more specific and takes into account what has been
collected to date (while, as noted previously, % Sales does a better job
of matching). Finally, and most importantly, the amount being esti-
mated under the Aged A/R method is NOT bad debt expense. Rather,
the amount being estimated is the ending ADA amount (remember,
the amount being estimated under the % Sales method is the bad debt
expense). This means we compute ending ADA and solve for bad debts
expense:
Continuing our previous example, in the first year the ADA and bad
debt expense are the same amount ($16,500) because in the first year
there are no opening ADA balances and no write-offs.
Our first year-end A/R is unchanged as follows:
Thus, the ending net A/R value is $133,500 because the bad debt
expense and ADA are now $16,500 (instead of the $20,000 under the %
Sales method) because of the different estimation.
For simplicity, we estimate the second year-end ADA with the same
percentages for each category as in year 1:
This means that at the end of the second year, the net A/R on the Bal-
ance Sheet is $172,300 (the ending A/R of $200,000 minus the estimated
ADA of $27,700) and the bad debt expense on the Income Statement is
$26,200.
Inventory
In a retail operation like our T-shirt vendor example in Chapter 2, items
are purchased and resold. Purchases of inventory are listed under current
12
See http://blog.freedmaxick.com/summing-it-up/bid/130347/Allowances-for-Doubt-
ful-Accounts (viewed November 25, 2014 2 p.m. EST).
Current Assets 75
assets until they are sold (inventory increases and cash decreases if the firm
pays immediately, or inventory increases and accounts payable increases
if the firm purchases the inventory on credit). When the items are sold,
inventory is reduced and an Income Statement account, which matches
the cost of the T-shirts to revenue, called cost of goods sold (COGS) or
cost of sales is created. The equation for the account is below, followed by
Walmart’s numbers for the year ending January 31, 2016.
Opening
Inventory + Purchases − Cost of Sales = Ending Inventory
$45.1 billion + $361.4 billion − $360.0 billion = $44.5 billion
Note that the opening and closing inventory numbers come from the
Balance Sheet, whereas the cost of sales number comes from the Income
Statement. Purchases is not provided in the financial statements and must
be computed as follows:
Walmart includes in cost of sales not only what it paid for the mer-
chandise it has sold but also the costs of its distribution and warehouse
facilities. Likewise, the ending inventory is not only what Walmart has in
its stores but also what it has in its warehouses.
In a manufacturing operation, the accounting process is more com-
plex. First, there are three broad categories of inventory (and within each
there may be thousands of individual accounts, one for each item at each
location):
Raw materials (the unchanged inventory that goes into the final
products),
Work-in-process (partially made products), and
Finished goods (the final products ready to be sold).
direct labor, which is the costs of wages and related benefits of all the em-
ployees who work directly on the product. The costs also include the cost
of operating the plant (e.g., rent, electricity, and maintenance) referred to
as overhead. The equation can be written as follows:
• Specific identification,
• FIFO,
• Average, and
• LIFO
whereas the remaining T-shirts (i.e., the ending inventory) are together
valued at $26 ($12 + $14). The $26 is less than the likely replacement
value of $28 (2 × $14), which is what the firm would have to pay to
replace the two remaining T-shirts if the cost was the same as the $14 it
paid for the last one. However, the FIFO value is closer to replacement
cost than the LIFO value as explained below.
LIFO is an Income Statement approach. LIFO costs (reduces inven-
tory value and increases COGS) in the reverse order of that purchased.
As the name implies, last-in first-out. This makes the Income Statement
expense more representative of the likely future costs and thereby pro-
vides a better estimate of future cash flows (assuming the firm maintains
a constant or increasing quantity of inventory). In our T-shirt example,
using LIFO, when one item is sold its cost is $14 which is that of the last
inventory item purchased. The remaining T-Shirts are together valued at
$22 ($10 + $12).
The FIFO ending inventory value on the Balance Sheet is closer to
replacement value because it includes more current prices. However, the
Income Statement using FIFO is not as good an estimate of future profits
because it includes older purchase prices. The LIFO ending inventory
value on the Balance Sheet is not as close to replacement value because it
uses older purchase prices. However, the Income Statement profit gives
a better estimate of future profits because it uses more current costs.
The trade-off between the two methods, FIFO and LIFO, is the same
trade-off as between the Aged A/R method (like FIFO, a Balance Sheet
approach) and the % Sales method (like LIFO, an Income Statement
approach).
LIFO has one very important caveat: It provides management the
possibility to manipulate reported profits by undertaking the economic
action of reducing the firm’s physical quantity of year-end inventory.
Consider again the T-shirt vendor in Chapter 2. Assume the firm starts
the year with three units of inventory that cost $10, $12, and $14 for
a total of $36. Regardless of whether the firm purchases any additional
units, FIFO will always cost the sale of the first unit of inventory at $10
regardless of when it occurs. However, for LIFO, the cost is $14 if the
firm purchases no new inventory during the year. If the firm buys another
Current Assets 79
unit for $15, then under LIFO the cost of the unit sold is $15 because
LIFO stipulates that the cost of the unit sold is always the cost of the last
unit purchased. Now imagine the firm bought no new inventory during
the year. It would cost one unit at $14 (rather than $15, which appears to
be the new market price), as shown in the example below. In subsequent
years, if no new inventory was purchased, it would cost the next unit at
$12 (rather than some amount above $15 if prices keep rising).
As shown below, failing to replace units sold makes no difference for
FIFO but can affect LIFO:
A firm using LIFO which increases its profits by selling inventory and
not buying replacements and thereby reducing the quantity of year-end
inventory (in this case from three to two units) is said to be “eating into the
80 ACCOUNTING FOR FUN AND PROFIT
LIFO layers.” (Note, we normally assume prices are rising, but this is not
always true. If prices are falling, LIFO produces a higher profit than FIFO.)
The above also assume inventory costing is done once a year, which
used to be true before the advent of computers. Today, many firms use
what is known as perpetual costing, which means the costing is done each
time a unit is sold. This makes the timing of purchases and sales impor-
tant. Consider the following scenarios:
• Purchase a T-shirt for $10,
• Purchase a T-shirt for $12,
• Sell a T-shirt for $20, and
• Purchase a T-shirt for $14
chooses FIFO and then is “locked in” to this accounting choice because
changing accounting choices requires an explanation and a transition year
with two sets of financial statement numbers. The firm’s profits before taxes
over the 3 years are $10 in the first year ($20 − $10), $12 in the second
year ($24 − $12), and $16 in the third year ($30 − $14). If taxes are based
on these FIFO-induced profits and the tax rate is 30 percent, the firm will
owe the government annual taxes of $3, $3.60, and $4.80, respectively.
By contrast, using LIFO will show profits before tax of $6 in the first
year ($20 − $14), $12 in the second year ($24 − $12), and $20 in the third
year ($30 − $10), with taxes equaling $1.8, $3.6, and $6, respectively. No-
tice that when we sum total profits before or after tax over the 3 years, FIFO
and LIFO result in the same 3-year sums ($38 and $26.60, respectively).
This also happens when we calculate total tax over the 3 years ($11.4).
If the firm will end up paying the same aggregate amount in taxes in the
long-term, why would it want to pay lower taxes now? Paying the govern-
ment later is generally preferred, as you can invest the funds you do not
give the government or borrow less. Essentially, by using LIFO for tax
purposes, you are able to delay a $1.2 payment from Year 1 to Year 3. The
amounts become interesting once they are in the millions, let alone the
$36.8 billion Exxon has currently delayed paying.13 (Chapter 8 provides
a detailed discussion on the time value of money.)
FIFO LIFO
Year Year 3 Year 2 Year 1 Total Year 3 Year 2 Year 1 Total
Revenue $30.00 $24.00 $20.00 $74.00 $30.00 $24.00 $20.00 $74.00
Cost $14.00 $12.00 $10.00 $36.00 $10.00 $12.00 $14.00 $36.00
Profit before
tax $16.00 $12.00 $10.00 $38.00 $20.00 $12.00 $ 6.00 $38.00
Tax (at 30 %) $ 4.80 $ 3.60 $ 3.00 $11.40 $ 6.00 $ 3.60 $ 1.80 $11.40
Net profit $11.20 $ 8.40 $ 7.00 $26.60 $14.00 $ 8.40 $ 4.20 $26.60
This means that firms with rising inventory costs would likely pre-
fer to use FIFO for the public (as it shows higher profits) and LIFO
for the government (as it delays paying taxes). Unfortunately, back in
13
According to its annual report, Exxon had deferred tax liabilities of $36.8 billion as
at December 31, 2015. See, ExxonMobil Inc. | 2015 Form 10-K | page 65. Tax pay-
ments will be discussed in more detail in Chapter 7.
82 ACCOUNTING FOR FUN AND PROFIT
1971, LIFO was not allowed in the U.S. for tax purposes and, since
prices were rising, most firms used FIFO in their public reports in order
to report higher profits to the public. After a considerable amount of
lobbying in 1972, Congress decided to allow firms to use LIFO for
tax purposes. However, Congress inserted an important caveat, firms
could only use LIFO for tax purposes if they also used LIFO in their
public reports.14
The above means a firm would save money by switching from FIFO
to LIFO by deferring tax payments but would have to report lower cur-
rent accounting profits to the public in order to do so. This is an impor-
tant point: Economically the firm would have higher cash flows this year
by deferring some of its tax payments, but to do so, it would have to lower
current reported accounting profits. Remember, as shown in the example
above, over the long-term it makes no difference.
Would you, as a manager, make the switch? Do you believe the market
will understand what you are doing or punish you for lowering profits? In
1973, eight firms listed on the Compustat database switched from FIFO
to LIFO. Their stock price rose, as apparently the market understood and
appreciated what they did. The next year 183 firms switched from FIFO
to LIFO.15
At one point, because of this tax effect, a majority of U.S. firms used
LIFO. Today the number is much less (one study of 5,000 public firms
puts the number at around 8.7 percent).16 There is also a downside risk
to using LIFO in periods of rising prices – liquidating inventory can in-
crease profits but may result in unexpected tax liabilities. Finally, a new
14
This remains true today and is, to this author’s knowledge, the only case in the U.S.
where a firm tax accounting choice is linked to the firm’s public reporting choice (i.e.,
LIFO conformity, IRS Code 472-2(e)).
15
See Gary C. Biddle and Frederick W. Lindahl, “Stock Price Reactions to LIFO
Adoptions: The Association Between Excess Returns and LIFO Tax Savings,” Journal
of Accounting Research Vol. 20, No. 2, Autumn 1982.
16
See, Kleinbard, Edward D., George A. Plesko, and Corey M. Goodman, “Is it Time
to Liquidate LIFO,” Tax Notes, Vol. 113, No. 3, pp. 237–253, October 16, 2006, and
ww2.cfo.com/accounting-tax/2006/07/the-battle-to-preserve-lifo/
Current Assets 83
problem with LIFO has arisen. Under IFRS, which are used by the Euro-
pean Union and others, LIFO is not allowed.17
What will the U.S. regulators do in response to IFRS? We shall see. (Your
author is betting on the U.S. continuing to allow LIFO for tax purposes
even if U.S. financial reporting standards are changed to align with IFRS
by prohibiting LIFO or Congress repealing the LIFO conformity rule.)
17
The European Union required all public firms to adopt IFRS for their consolidated
accounts by 2005. IFRS are those issued by the International Accounting Standards
Board (IASB) an independent body based in Europe. Prior to 2001, when the IASB
changed its nomenclature to IFRS, these standards were called International Account-
ing Standards (IAS).
84 ACCOUNTING FOR FUN AND PROFIT
Assume Robert is given $30 million to explore for oil and that it costs
$10 million per well that is dug, meaning he can dig up to three wells. If
he finds oil, he gets $14.5 million per well. If there is no oil, he loses all
$10 million. The most Robert can earn if he punches three holes in the
ground and finds oil in all three is $13.5 million (three times the differ-
ence of $14.5 million and $10 million).18 To ensure he wins the contest,
JR would have to earn more than $13.5 million.
JR has 2.7 million barrels of oil on hand that his dad had purchased
for $14 a barrel (or a total of $37.8 million). The current price of oil in
1978 is $19.50 per barrel and the current selling price is $20 per barrel.
In the normal course of business, JR expects to sell 2 million barrels in the
next 6 months. Now consider the following: If JR sells 2 million barrels at
$20 per barrel, his revenue is $40 million. If he uses FIFO, his accounting
cost is $28 million and his accounting profit is $12 million. This would
be reported profit under LIFO as well if he buys no new oil. Note that his
actual economic profit is really only $1 million (the $20 selling price less
the $19.50 replacement cost times the 2 million units). However, by using
FIFO or not replacing the inventory, JR also gets the difference between
the replacement cost of $19.50 and the $14.00 his dad paid. This occurs
because the accounting records have the inventory valued at the $14 price
his dad paid. This difference is an unrealized and unrecorded holding gain
(of $5.50 per barrel in this case). It is also sometimes referred to as a hidden
reserve.
JR will win by showing a $12 million profit unless Robert drills three
wells and finds oil in all three – a very unlikely event. However, JR is not
willing to risk Robert winning, no matter how unlikely. How can JR en-
sure he earns more than $13.5 million for a guaranteed win?
JR realizes that he has to sell more than 2 million barrels of oil to
ensure a win. To do so, JR lowers his selling price from $20 to $19.05 per
barrel and sells all 2.7 million barrels instead of the 2 million he would
have sold at a price of $20.00. Now, JR is in fact losing $0.45 per barrel
on an economic basis (the replacement cost of $19.50 is $0.45 higher
18
This is a simplified example because in reality, different wells would have different
costs and the total amount they could be sold for would depend on the quantity of oil
found and its extraction costs.
Current Assets 85
19
The J.M. Smucker Company owns brands, such as Smucker’s, Folgers, JIF, Pillsbury,
and Crisco, among many others. See J.M. Smucker Inc. | 2015 Annual Report |.
86 ACCOUNTING FOR FUN AND PROFIT
crease in sales, the firm profits fell by 39.0 percent (from $565.2 million
to $344.9 million). Management claims one reason for the profit decline
was the integration and debt costs of an acquisition (i.e., Big Heart Pet
Brands for $5.9 billion).
As can be seen from the previous table, current assets rose 33.3 per-
cent, much more than the 1.4 percent increase in sales. The firm had
an 18.2 percent drop in cash, which makes sense given the acquisition
and additional debt incurred. Cash and other current assets combined
remained about the same total dollar value as accounts receivable. Inven-
tory is the largest item, roughly three times the size of accounts receivable.
Both accounts receivable and inventory increased significantly. Why did
accounts receivable increase so much more than sales (39.0 percent versus 1.4
percent)? Probably due to the acquisition. Likewise, the increase in inven-
tory may be due to the firm stocking up on key raw materials, building
up inventory for an expected increase in sales, or primarily as a result of
the acquisition. These are the types of considerations a user of the annual
report might have. The key point is that the reader should now be able
to follow this type of discussion and understand these components of the
Balance Sheet.
The next chapter will examine noncurrent assets including property,
plant, and equipment; patents; trademarks; and other noncurrent assets.
CHAPTER 6
Long-Term Assets
Long-term assets are generally divided into three broad groups: long-term
marketable securities; property, plant, and equipment (PP&E); and other
assets. The accounting choices for long-term marketable securities are
either the same as the choices for short-term marketable securities and
merely have a different classification, or are much more complex.1 Long-
term marketable securities will be discussed in Accounting for Fun and
Profit: Understanding Advanced Topics in Accounting. This chapter will
focus on PP&E and intangible assets.
As can be seen from the information below, in its 2015 fiscal year,
Apple Inc. generated $233.7 billion in revenue and $53.4 billion in profit
with total assets of $290.5 billion. The total assets were split between
$89.4 billion of current assets and $201.1billion of long-term assets.
The long-term assets included $164.1 billion of long-term marketable
securities (remember that these are classified as long-term because Apple
does not intend to sell them within a year); $22.5 billion of PP&E;
and $13.5 billion of other assets. Chapter 12 will delve into the numer-
ous ways that exist to relate accounting numbers to each other, but for
now, we can note that Apple generated $10.39 in revenue and $2.37 in
profit for each dollar of year-end PP&E. By contrast, in its 2015 cal-
endar year, ExxonMobil Corporation generated $1.07 in revenue and
$0.06 in profit per dollar of PP&E. Apple (a computer/cell phone firm)
required much less in PP&E than Exxon (an energy supplier) to generate
each dollar of revenue.
1
As noted in the last chapter, the classification as long-term is based both on intent
(that the firm does not intend to sell the securities within the next year) as well as the
assets useful life.
88 ACCOUNTING FOR FUN AND PROFIT
PP&E2
As with any asset, when a firm acquires PP&E (i.e., gains the physical cus-
tody or title to it) an asset is increased and either cash is reduced or a liability
(accounts payable or debt) is increased (or there is a combination of the
two if a partial payment is made). The cost of PP&E includes all legal fees,
transportation, and even the costs of setting the equipment up for its first
use, if such a cost is significant. If a firm builds the PP&E asset, its cost in-
cludes all actual expenditures incurred through completion of construction,
even financing cost. What if a firm exchanges one of its assets plus some cash for
another, similar to an individual trading in an old car for a new one plus an
additional cash payment? The new asset is valued at its estimated cash price.
In general, firms try to match costs to the revenues that the expenses
helped produce. However, property (i.e., land) is recorded at cost and
then normally kept at cost. Why is the cost of land not matched to the rev-
enue it helps the firm produce? Because land is a unique geographic loca-
tion, a spot on the globe, and not thought to deteriorate or change over
time. Is the cost of land ever changed? Temporary changes in market value
are ignored because the market value of land, unlike an actively traded
2
Taken from the firms’ annual 10-K reports to the Securities and Exchange Comis-
sion (SEC).
Long-Term Assets 89
Exhibit 6.1
Straight-line depreciation
50000
40000
30000
$
20000
10000
0
1 2 3 4 5 6
Year
far the most common method used by firms for financial reporting. It
is simple to compute and understand and has an income smoothing
effect.
A potential critique of the straight-line method is that it does not
match how the asset actually deteriorates over time. There are many dif-
ferent methods where the reduction is meant to match how the asset ac-
tually declines in value, with higher amounts in the early years and lower
amounts in the later years. These methods compute a rate which is ap-
plied to the undepreciated balance of the asset. The most popular of these
methods is called double declining balance because it creates an annual
rate using a numerator of 200 percent.
Annual Depreciation = (Cost − Accumulated Depreciation to date) ×
200%/Life of Asset
Using the same example as above, the rate would be 40 percent
(200%/5-year life). The depreciation in each of the 5 years is then com-
puted as:
Exhibit 6.2
Double declining balance
50000
40000
30000
$
20000
10000
0
1 2 3 4 5 6
Year
As shown in Exhibit 6.2, the graph has a steeper slope in the early
years and then levels off.
Note that the double declining balance method does not include a
salvage value in the computation because, implicitly, the ending value
after depreciation done in this way is the salvage value.3
It is important to note that neither of these methods is meant to value
the asset. Both are meant to match a cost to the revenue. The difference
between the methods is whether the cost is spread out evenly over time or
has a higher amount in the early years. In fact, the economic value of the
asset may be higher or lower than the accounting value. Unlike current
assets, long-term assets, such as plant and equipment, are not normally
adjusted up or down to market values. Accounting is relating the histori-
cal cost of the asset (i.e., what the firm incurred) to the revenues that the
asset helps the firm generate.
3
In some computations, the depreciation stops when the salvage value is met. For
example, assuming a salvage value of $10,000, the depreciation in year 3 would be
$4,400 and there would be no additional depreciation in years 4 and 5.
92 ACCOUNTING FOR FUN AND PROFIT
How does a firm estimate the life of an asset and its salvage value? As
with all estimates, past experience, industry averages, and management’s
beliefs are used here. Normally, the longest life used is 40 years. However,
there are many assets (e.g., buildings) that have lives much longer than
40 years. What happens when the asset lasts longer than the estimate used for
the depreciation? By incorrectly estimating the asset’s life at less than its
actual, a firm records too high a depreciation expense over the estimated
life and then nothing in the final years of the asset’s use. Once the asset is
reduced to its salvage value, the computation stops and there is no further
depreciation expense, even though the asset is still in use. This means that
all else equal, accounting profits in future years will be higher because
there is no longer a reduction from depreciation. Remember, depreciation
is an expense spreading the cost of an asset out over its useful, revenue-
generating life. If the asset is fully depreciated but is still in use, there is
no additional depreciation allocation for the original asset and the firm
does not yet have the depreciation cost of a replacement. However, it is
important to remember that what increases in this case is the accounting
(not economic) profit based on the accounting deprecation.
An Accountant in Paris
Once upon a time, (around 1990) there was a hypothetical large firm
located in the center of Paris, France. The firm had an accounting profit
of roughly $5 million4 a year, more or less, over the prior 10 years. Then,
the firm received an offer of $100 million for its 80-year-old plant. The
buyer did not really want the old dilapidated plant. The buyer wanted the
land the plant was on. The selling firm accepted the offer and built a new
state-of-the-art plant just outside Paris for $50 million. How much profit
(ignoring taxes) did the firm make in the year it accepted the offer? (Try to
answer before reading on.)
About $105 million. The firm probably still made the regular $5 mil-
lion, and it also had a gain of close to $100 million on the sale of the
old plant. The gain on the sale of the plant is the selling price less the
4
The original story had the firm earning 20 million French Francs, which have been
converted to US dollars.
Long-Term Assets 93
accounting value at the time of sale. Does it matter what the plant’s original
cost was 80 years ago? It does not matter because 80 years later, at the time
of sale, the accounting value would have been close to zero. The building
would have been reduced to zero (assuming there is no salvage value) on
the Balance Sheet 40 years earlier (e.g., the plant was 80 years old and
the longest depreciation period is normally 40 years). The only value on
the Balance Sheet would have been for the land, at its cost from 80 years
ago because land is usually kept at its original cost. The gain on the sale is
$100 million less the original cost of the land 80 years ago.
What about the purchase of the new plant? Does that not reduce the
profit? Yes, but only by the depreciation and only once the plant is in
operation. The accounting for the new plant is asset up $50 million, cash
down $50 million.
What is the profit the next year? (Again, try to answer before reading on.)
About $3.75 million. The firm probably made close to the $5 million
it made with the old plant, maybe a bit more if the new plant is more effi-
cient. However, the firm now has depreciation expense from the new plant.
The amount, using the straight-line method, would be the initial cost of
the plant divided by 40 years ($50 million/40), if we assume there is no sal-
vage value. This would mean a depreciation cost of $1.25 million per year.
The firm then fired its plant manager. According to the accounting
records, he had been making about $5 million a year with virtually no in-
vestment in PP&E. Then he had a spectacular year making $105 million
(21 times his prior 10-year average). This was followed by a truly horrible
year of only $3.75 million and this last profit was made after investing
$50 million in PP&E. This represents a meager return of 7.5 percent
($3.75/$50), well below what the firm could have earned by investing
in risk-free government bonds (in 1990 governments bonds were paying
well above 10 percent).
As with the “Accountant in Dallas” example in the prior chapter, ac-
counting is not about economic profit. The manager was not making an
economic profit of $5 million. There was an economic cost in using the
plant. Also, despite the accounting records showing virtually no invest-
ment in PP&E, the old plant did have a value (just not in the account-
ing records). Perhaps it was the wrong decision to build the new plant
because it provided insufficient returns.
94 ACCOUNTING FOR FUN AND PROFIT
5
When the depreciation expense is reduced (reset) to zero at the end of the year (with
a credit), the retained earnings account (part of owners’ equity) is also reduced (with
a debit).
Long-Term Assets 95
Note that with double declining balance, the rate would be changed
to 50 percent (200%/4) applied to the remaining net balance (Cost −
Accumulated Depreciation).
Also note that the life does not have to be time related (years or
months). Other common examples would be machine hours (how many
hours will the machine be used before it is scrapped or sold) and miles
(how many miles will the car be driven before it is sold).
Furthermore, depreciation is normally prorated for assets purchased
during the year (e.g., if the asset was purchased on March 1 for a firm
with a calendar year-end, the first calendar year would have 10/12 of a
full year’s depreciation and the last calendar year would receive 2/12).6
6
At one point, to simplify the calculation, firms would, regardless of the actual date
the asset was placed into service, record a full year’s depreciation in the year of pur-
chase and nothing in the final year or alternatively record half a year’s depreciation in
the year of purchase and half a year’s depreciation in the final year. Today, with the ease
of computing the pro-rating it is hard to justify this practice.
96 ACCOUNTING FOR FUN AND PROFIT
Current Liabilities
The accounting for current liabilities may seem familiar because many
of the accounts are mirror images of those in current assets. With cur-
rent liabilities, a firm is on the opposite side of the transaction from that
of current assets. Instead of selling, using, or converting something to
cash within a year as it does with current assets, the firm has purchased
something and must pay for it within a year or has received prepayment
and must provide goods or services within a year. Current liabilities are
current obligations to transfer assets or provide services in the next year
and will generally be satisfied with current assets. Common examples of
current liabilities are discussed below.
Bank Debt
Bank debt is a short-term or revolving (automatically renewed) loan.
It can be thought of as negative cash. Most firms do not actually nego-
tiate short-term loans as they need them. A firm instead arranges a line
of credit from the bank before its actual funding requirements occur.
This allows the firm to make payments even when it has no available
cash in its bank account and without having to get a new loan ap-
proved each time—by prior agreement, the bank automatically lends
money to the firm up to a certain amount. The rate and terms are all
set in advance (the rate usually is a set percentage above what is called
the “prime rate”).1 Banks charge a fee for the line of credit, usually
1
The prime rate is a rate banks give their best customers. Currently it is about 3 per-
cent above the U.S. government discount rate. Depending on a firm’s product market
and financial situation, the company will pay anywhere from slightly below to well
above this rate.
98 ACCOUNTING FOR FUN AND PROFIT
falling around 30 basis points (i.e., 0.3 percent of the total possible
loan amount). The bank charges this fee simply for making the line
of credit available and regardless of whether the firm actually borrows
any funds (e.g., a firm would pay $3,000 a year to have a $1 million
line of credit open).
Payables
There are many different types of amounts firms have to pay based on
their operations. These amounts are called payables and include:
2
If a firm does indeed fail to pay, it is likely to be in financial distress and will have
greater problems than estimating allowances.
Current Liabilities 99
in some sense.3 On the other hand, the accounting choices for tax
policy are designed to optimize tax payments, which normally means
delaying them because, all else equal, a firm would rather pay the
government later.
The deferred tax account represents a difference in how tax expense is
matched to income and how taxes are actually paid. Let us therefore look
at how tax expenses are recorded before examining how deferred taxes are
recorded.
For example, imagine a firm with public reporting that shows profit
before tax of $100 million a year for 3 years (a total of $300 million over
the 3 years), whereas taxable income is reported to the government at
$80 million, $100 million, and $120 million (still totaling $300 million
over the 3 years). Further assume the corporate tax rate is 30 percent.
The actual taxes paid are 30 percent of the taxable income that the firm
reported to the government, which means $24 million, $30 million, and
$36 million for a total of $90 million over the 3 years.
How does the firm record the taxes paid to the government? As will be
shown in more detail with step-by-step journal entries below, the pay-
ments are reflected on the Balance Sheet (either as a decrease in cash or an
increase in an amount owed to the government) with some corresponding
expense on the Income Statement. You might think that the firm should
have the tax expense recorded on the Income Statement equal the amount
actually paid or owed in taxes.4 However, remember that accountants try
to match expenses (costs) to revenue. Recording $24 million, $30 mil-
lion, and $36 million as the tax expenses over the 3 years, as shown in
Exhibit 7.1, would do a poor job of matching the tax expense to the rev-
enue. The firm’s revenue was the same every year, so the best way to match
3
Although the accounting policies for public reporting are supposed to reflect the un-
derlying economics, as prior chapters discussed, the firm can choose to have more of a
Balance Sheet approach (which more accurately reflects the value of its assets) or more
of an Income Statement approach (which is a better predictor of future cash flows).
4
For simplicity, tax paid is the taxable income times the tax rate. In fact, the taxes are
not all paid by year-end, so the taxes owed for the year would have been partly paid
and there would be a short-term liability of taxes payable for the difference.
Current Liabilities 101
Exhibit 7.1
Comparison of tax expenses based on payment vs. rate
(millions) Year 3 Year 2 Year 1 Total
Taxable income $120 $100 $ 80 $300
Tax rate 30% 30% 30% 30%
Taxes paid $ 36 $ 30 $ 24 $ 90
Poorly matched Year 3 Year 2 Year 1 Total
Public reported profit before tax $100 $100 $100 $300
Tax expense based on taxes paid $ 36 $ 30 $ 24 $ 90
Net profit based on taxes paid $ 64 $ 70 $ 76 $210
Properly matched Year 3 Year 2 Year 1 Total
Public reported profit before tax $100 $100 $100 $300
Tax expense based on tax rate $ 30 $ 30 $ 30 $ 90
Net profit based on tax rate $ 70 $ 70 $ 70 $210
tax expenses to revenues would be to apply the 30 percent tax rate to each
year’s public reported profits of $100 million.
A couple of notes: First, in the example above, the public reported
income was the same in all 3 years. This does not have to be true for the
example to be valid. Second, in this example, the difference completely
reverses out over 3 years because the 3-year totals are the same for both tax
and public reporting. In reality, reversals can take a very long time, even
decades, and while one tax deferral reverses others may be set up, causing
the total deferred tax to grow.
What causes the differences in public and tax reporting? There are in fact
two types of differences in a firm’s public and tax reporting of revenues
and expenses. Some are permanent (i.e., certain revenues and expenses
are never included in tax reporting) and some are temporary (i.e., the
firm recognizes revenues or expenses in a different year for public report-
ing and tax purposes). The permanent ones impact the firm’s effective
tax rate and have no effect on the difference between taxes paid and tax
expense described in Exhibit 7.1. The temporary ones reverse out over
time and cause the matching problems between tax paid and tax expense
described above.
102 ACCOUNTING FOR FUN AND PROFIT
Exhibit 7.2
Taxable vs. public reported depreciation
(millions) Year 3 Year 2 Year 1 Total
Profit before depreciation and tax $140 $140 $140 $420
Tax depreciation $ 20 $ 40 $ 60 $120
Taxable income $120 $100 $ 80 $300
Tax rate 30% 30% 30% 30%
Taxes paid $ 36 $ 30 $ 24 $ 90
$120 over the 3 years), netting the taxable income shown in Exhibit 7.2
(i.e., $80 million, $100 million, and $120 million). For public reporting
purposes, the depreciation is $40 million a year (the $120 million depre-
ciated evenly over the 3 years), netting the public reporting profit before
tax shown in Exhibit 7.2 (i.e., $100 million each year).
As seen in Exhibit 7.2, the firm has a difference between tax paid (or
payable) and tax expense.5 This results in deferred tax in the public finan-
cial statements.
5
For simplicity, it is assumed that all taxes are paid during the year. In reality, only
some portion of total taxes would be paid during the year leaving a tax payable at the
end of the year, that would be paid the following year.
104 ACCOUNTING FOR FUN AND PROFIT
6
Solar panels placed into service by December 31, 2011, could be 100 percent depre-
ciated in 1 year. Certain qualifying equipment placed into service by December 31,
2013, had a 50 percent “bonus” depreciation. Currently, the U.S. government allows
solar panels to be depreciated over 5 years.
Current Liabilities 105
Exhibit 7.3
Taxable vs. public reported depreciation
(millions) Year 3 Year 2 Year 1 Total
Profit before depreciation and tax $140 $140 $140 $420
Tax depreciation $ 40 $ 40 $ 40 $120
Taxable income $100 $100 $100 $300
Tax rate 30% 30% 30% 30%
Taxes paid $ 30 $ 30 $ 30 $ 90
Note that there is in fact a separate deferred tax account for each item with
a timing difference. In most cases, the firm will have lower revenues or higher
expenses for tax purposes, resulting in a deferred tax liability. Firms normally
net the current deferred tax asset and liability and net the long-term deferred
tax asset and liability, resulting in one current item and one long-term item.
What if there is a change in the tax rate? Does this affect deferred taxes?
Yes, but only when enacted into law—proposed tax changes are ignored.
Once a tax rate is changed, the timing difference is multiplied by the new
rate, the deferred tax is adjusted, and the impact of the rate change either
increases (if the rate went up) or decreases (if the rate went down) the
current year’s income tax expense.
Assume that in our example above, the income tax rate decreased from
30 percent to 20 percent prospectively at the end of the second year, which
means that the change in rate will be applied to year 3 but not year 2. The
timing difference at the end of year 2 is $20 million as before (the cumulative
depreciation for tax purposes is $60 million + $40 million = $100 million
vs. the cumulative depreciation for public reporting purposes is $40 million
+ $40 million = $80 million). The deferred tax is $6 million based on the
$20 million difference times 30 percent. However, because of the change in
the law, when the reversal occurs it will now be only $4 million (the $20 mil-
lion times the new rate of 20 percent). In year 2, the deferred tax would have
to be lowered (the benefit of the lower rate is recognized) by $2 million (from
$6 million to $4 million), and the tax expense would be reduced by $2 mil-
lion (from $30 million to $28 million). In year 3, the tax expense is now based
on the lower rate, and the deferred tax already adjusted in year 2 is reversed.
If the tax rates went up instead of down, the opposite would occur
and the deferred tax liability and the tax expense would be increased. The
benefit or future cost is adjusted in the year the tax change is enacted into
law and then the new rate is applied in future years.
One final tax-related issue has to do with how tax losses are treated.
If a firm does not have any profits for tax purposes, it pays no taxes. But
what if a firm has losses? Does it get a tax break? It depends. In the United
States, a firm can normally apply losses in the current year against profits
from the prior 2 years and recover taxes paid through a refund by the gov-
ernment. This means that in a year in which a firm records a loss before
tax (i.e., negative profit before tax), the firm may show recoverable taxes
that reduce the net loss after tax. Of course, this only happens if the firm
had profits and paid taxes in the prior 2 years. If a firm had no profits
in the prior 2 years, or the losses in the current year are greater than the
profits of the prior 2 years, the loss (or unused portion of the loss) can be
applied (“carried forward”) against future profits for a set number of years
(currently 7 years in the United States). This means the firm will pay no
taxes until it earns back the amount lost.
Can the value of not paying taxes in the future be included in the current
financial statements? Sometimes. For example, a tax loss carryforward can be
applied against deferred tax liabilities. This is done by reducing the current
year’s net loss on the Income Statement (with a tax recovery line on the In-
come Statement) and reducing the deferred tax liability on the Balance Sheet.
Other Liabilities
This category includes a host of other items that, as with “other assets,” are
not large enough in amount to merit their own line on the Balance Sheet.
(Though if they are material for an individual firm, then they should be
disclosed separately in their own line.) This includes items such as:
7
In most cases, after some period of time, unclaimed amounts are given to the
government.
CHAPTER 8
1
Part of this chapter is copied from Asquith and Weiss: Lessons in Finance © 2016.
Reprinted with permission.
112 ACCOUNTING FOR FUN AND PROFIT
$100 $105.00
$ 5 $ 5.25
$100 × 5% = $5 $105 ×5% = $5.25 $110.25
|-------------------------------------|---------------------------------|
Today End year 1 End year 2
FVn = PV × (1 + r)n
PV = FVn / (1 + r)n
interest rate is 8 percent.2 Which is worth more: the $12,000 today or the
$18,000 in 4 years?
To answer this, we have to choose one date and then compare the value of
the two options on that date (it can be any date: today, at the end of 4 years,
or any date in between). Let us start by finding the value of the two options
at the end of 4 years. By definition, Option 2 is $18,000 in 4 years. What is
the value of Option 1 in 4 years? That is, how much is $12,000 today worth in 4
years? From our equations above, with PV = $12,000, r = 8%, and n = 4.
0 1 2 3 4
We can also answer the question of which option is worth more by
comparing the two options today. By definition, the value of Option
1 is $12,000 today. What is the value of Option 2 today? That is, how
much is $18,000 in 4 years, worth today? Using our equation above with
FV = $18,000, r = 8%, and n = 4.
This has a PV = $18,000 / (1.08)4 = $13,230.54
Taking the $18,000 in the future and computing its value today is
called discounting.
Visually:
(Option 1) $12,000.00
vs.
(Option 2) $13,230.54 r = 8% $18,000
|----------------------|------------------|------------------|-------------|
0 1 2 3 4
2
In a business context, this is equivalent to investing $12,000 today and receiving
$18,000 in 4 years (the original $12,000 plus interest). The “appropriate” interest rate
reflects the risk of the investment, which includes inflation.
THE TIME VALUE OF MONEY 115
FVn = PV × (1 + r)n
Annuities
An annuity is a contract with equal periodic payments. Importantly, de-
spite the name of “annuity,” the periods do not have to be annual. Home
mortgage payments are a type of annuity (a large sum is borrowed, and
then equal monthly payments are made for the next 10, 20, or 30 years).
Also, most debt contracts are the combination of an annuity (the periodic
interest payment) as well as a final lump sum repayment.
3
There is no reason that the rate could not be stated for a time period of less than a
year (e.g., 2 percent every 3 months). It is simply convention to state the rate for a
year, which then has to be divided by the number of times it is compounded during
the year.
4
It is also called the annual percentage yield (APY) that readers may recognize from
their credit cards or mortgages.
THE TIME VALUE OF MONEY 117
The above can also be computed by taking out the equal periodic pay-
ment and multiplying by the sum of the values as follows:
5
Apply the formula APR = (1 + r / j)n × j − 1. In this case, (1 + 12% / 2)1 × 2 −
1 = 12.36%.
118 ACCOUNTING FOR FUN AND PROFIT
How much would the firm have to pay on January 1, 2014, to eliminate
the debt (e.g., a lump sum, one-time payment instead of the four $300,0000
payments) if the discount rate is 12 percent compounded semiannually (or 6
percent every 6 months)? The answer is $1,039,532.
Alternatively, how much would the firm have to pay on December 31,
2015, to eliminate the debt (e.g., a lump sum, one-time, payment instead of
the four $300,0000 payments) if the discount rate is 12 percent compounded
semiannually (or 6 percent every 6 months)? The answer is $1,312,385.
Note that once you know the FV, you can discount it to get the PV,
and once you know the PV, you can compound it to get the FV:
Ordinary annuity:
$300,000 $300,000 $300,000 $300,000
|---------------------------|--------------------|-------------------|---------------------|
1/1/2014 6/30/2014 12/31/2014 6/30/2015 12/31/2015
$1,039,532
Annuity due:
$300,000 $300,000 $300,000 $300,000
|------------------------------|--------------------|--------------------|-------------------|
1/1/2014 6/30/2014 1/1/20156 6/30/2015 12/31/2015
$1,101,904
6
A one-day difference, December 31, 2014, and January 1, 2015, is ignored (i.e., the
one-day interest on $1 million at 5 percent is about $137).
120 ACCOUNTING FOR FUN AND PROFIT
have three payments at the same time (June 30, 2014; December 31,
2014; and June 30, 2015). The difference between the two annuities is
that the annuity due’s four payments start with a payment on the PV
date of January 1, 2014, whereas the ordinary annuity’s first payment is
6 months later on June 30, 2014. Thus, the difference is the value of one
payment today (in this case on January 1, 2014) vs. one payment at the
end (in this case on December 31, 2015).
How much is a payment of $300,000 made on January 1, 2104, worth
on January 1, 2014? It is worth exactly $300,000.
How much is a payment of $300,000 made on December 31, 2015,
worth on January 1, 2014? It is worth $237,628 (using our formula, that
would be PV = FV4 / (1 + r)4 = $300,000 / (1.06)4 = $237,628).
The difference in the value of an annuity due and an ordinary annu-
ity in the above example is: $300,000 − $237,628 = $62,372. This is
the same result as comparing the total of the annuity due and the total of
the ordinary annuity ($1,101,904 − $1,039,532 = $62,372) because all
other payments are identical.
This means that, at any positive interest rate, an annuity due is worth
more than an ordinary annuity (e.g., receiving a payment on January 1,
2014, is preferred over receiving a payment on December 31, 2015).
Does an ordinary annuity or an annuity due have a higher FV? Think
about this for a moment. It is the same answer as above: The annuity due
(which has its first payment on January 1, 2014) compounds more interest
than the ordinary annuity (which has its first payment on June 30, 2014).
Remember that the math has to equate. Discounting (going back to
the present) or compounding (going forward to the future) has the same
answer of which annuity is better. Let us find the exact difference in val-
ues to prove it. In the previous example, the ordinary annuity has a pay-
ment of $300,000 on the future date of December 31, 2015. At the FV
date of December 31, 2015, that payment is worth $300,000. On the
other hand, the annuity due has a $300,000 payment on January 1, 2014.
On December 31, 2015, the annuity due’s first payment will be worth
$378,743 (because $300,000 × (1.06)4 = $378,743). Thus, comparing
the FVs of these two payments, ordinary annuity ($300,000) and of the
annuity due ($378,743), shows us that the annuity due is worth $78,743
more on December 31, 2015, over the ordinary annuity.
THE TIME VALUE OF MONEY 121
Just to close the math loop, note that the annuity due was worth
$62,372 more on January 1, 2014, and $78,743 more on December 31,
2105. These two numbers equate: the PV of $78,743 is $62,372, and the
FV of $62,372 is $78,743.
Most car leases are set up as annuity dues with 3 or 4 years of equal
monthly payments and the first one due at signing (and often some ad-
ditional up-front charges). Why are car leases set up as annuity dues? Be-
cause the annuity due is worth more? Not necessary, it all depends on the
payments. Although the deal can be set in multiple ways, let us focus
on three: a lump sum payment at the start (the cash price of the car), an
annuity due, or an ordinary annuity. The lump sum payment at the start
means the buyer is paying the full cost of the car at the beginning and
no future payments are owed. Let us set the cost of the car at a specific
amount and examine the difference in paying with an annuity due vs. an
ordinary annuity.
What are the periodic payments in our example if the one-time cash pay-
ment today (i.e., the purchase price) is $22,038? If the payments are made
at the start of the year using an annual percentage yield (APY) of 12.36
percent (which means 12 percent compounded semiannually), then the
annuity due would have four equal payments of $6,000 (on January 1,
2014; June 30, 2014; January 1, 2015; and June 30, 2015) and the or-
dinary annuity would have four equal payments of $6,360 (on June 30,
2014; December 31, 2014; June 30, 2015; and December 31, 2015).
How do we calculate the periodic payments of $6,000 for the annuity
due option and $6,360 for the ordinary annuity option? We use the formula
above but this time solve for an unknown payment to equal the PV (pur-
chase price) of $22,038.
Annuity due:
$22,038
Pmt = $Y Pmt = $Y Pmt = $Y Pmt = $Y
|---------------------------|--------------------|--------------------|-------------------|
1/1/2014 6/30/2014 1/1/2015 6/30/2015 12/30/2015
Ordinary annuity:
$22,038
Pmt = $X Pmt = $X Pmt = $X Pmt = $X
|-----------------------------|--------------------|--------------------|-------------------|
1/1/2014 6/30/2014 12/31/2015 6/30/2015 12/31/2015
Bond Valuation8
There are numerous types of bonds, but the most common is an ordinary
bond where the issuer agrees to make periodic payments plus a single
large payment at the end of the bond’s life. This single payment at the
end of the bond’s life is called the par or face value of the bond. The is-
suer also makes equal periodic payments (twice per year is the standard
in the United States and once is the standard in Europe) over the life of
the bond. These equal periodic payments are called the coupons and are
usually set as a fixed percentage (called the coupon rate) of the par or face
value of the bond.
7
A total of $22,038 also equates to a monthly annuity due payment of $1,024 vs.
a monthly ordinary annuity due payment of $1,034 with 24 monthly payments or
$722 and $729 with 36 monthly payments or $572 and $577 with 48 monthly pay-
ments, respectively, at an interest rate of 12.36 percent APY (or 11.7107 compounded
monthly).
8
A bond is a long-term debt obligation. Bonds are discussed in more depth in Chapter 9.
THE TIME VALUE OF MONEY 123
The $1 million is the face value or par value of the bond. The $50,000
is the annual coupon, and it could be stated as a rate (called the coupon
rate or stated rate). In this case, the coupon rate would be 5 percent of the
par value (5% × $1,000,000 = $50,000). Knowing the coupon rate and
the face value gives you the coupon. Knowing the coupon and the face
value gives you the coupon rate.
What is the bond worth today, at the start of the bond’s life? This depends
on the market rate or yield of the bond. This is the interest rate the market
will pay given the terms of the bond, the economic conditions, and the
market’s assessment of the likelihood the firm will be able to make all
payments. It is the discount rate which equates the price of the bond in
the market and the bond’s payments. The market rate fluctuates over time
(in contrast to the coupon rate which is set in the terms of the bond). Let
us start by setting the market rate equal to the coupon rate of 5 percent.
The bond’s price is computed with a PV calculation:
PV = $1 million
In this case, the bond is issued at par, which means the bond’s issue
price (e.g., the price at the time the bond is first issued) equals its par value.
Whenever the bond is at par, the market rate and the coupon rate are the
same. Conversely, whenever a bond’s coupon rate equals the market rate,
the price of the bond is the par value. Note that the coupon rate deter-
mines the amount of the coupon (in this case, 5% a year × $1 million
124 ACCOUNTING FOR FUN AND PROFIT
par value = $50,000 a year). Once set, the coupon does not change (it is
a contractual amount).9
Now, what happens if the market rate falls?10 The price (what someone
else would pay you for the bond) of the bond will increase. This occurs
because the denominator in the discounting formula above is the market
rate. If you hold a numerator constant and lower a denominator, the result
increases. Take the extreme case: Imagine that the market interest rate falls
to a rate of zero 2 years after the bond is issued. What is the value of the bond?
$1,000,000
paid paid $50,000 $50,000
|-----year 1-----|-------year 2------|------year 3------|------year 4------|
At the start of the third year, the bond has three payments remaining: two
interest payments of $50,000 each as well as the final par value payment of
$1 million. In other words, by the end of the bond’s life, it will pay $1.1 mil-
lion. At a 5 percent market rate, the bond would have a price of $1.0 million.
9
There are some bonds where the coupon rate is based on a market rate (e.g., prime
plus 2 percent), but these are more complex bonds and their pricing would be much
more difficult.
10
This could happen either because the government rate falls or because the firm’s cash
flows to repay the debt become less risky.
THE TIME VALUE OF MONEY 125
rate is 3 percent (above 0 percent but below 5 percent), will the price of the
bond be more or less than $1 million? More or less than $1.1 million? Write
down your answer.
We have a simple way to understand what happens to bond prices as
market rates rise and fall. The approach also helps us check any calcula-
tions to ensure they are not seriously wrong. The maximum price of the
bond, which occurs at a 0 percent rate (extreme even for safe government
bonds), is $1.1 million. As shown above, at a 0 percent rate, the price of
the bond is the sum of all future payments (in this case, the two coupons
of $50,000 each and the par value of $1 million). The price of the bond at
par, when the market rate equals the coupon rate, is $1 million.
If the market rate rises above the coupon rate, the price of the bond
falls below the par value. If the market rate falls below the coupon rate,
the price of the bond will increase above par but will remain below the
maximum price from using a zero coupon rate.
Why does the price of a bond decrease when market rates increase, and in-
crease when market rates decrease? Because the numerator is the bond’s cou-
pons and par value that are set by the bond contract and do not change,
whereas the market rate that can change is in the denominator.
PV = Pmt / (1 + r)1 + Pmt / (1 + r)2 + . . . + Pmt / (1 + r)n + Par Value / (1 + r)n
This can be seen using the par value and coupon rate of our example:1112
Face value Coupon rate Market rate Bond value start of year 3
$1million 5% 0% $1.100 million
$1 million 5% 3% $1.038 million11
$1 million 5% 5% $1.000 million
$1 million 5% 7% $0.964 million12
The above can also be understood with the following example. Imag-
ine our firm issues a second $1 million face value bond at the start of
year 3. This bond will have a 2-year life, so it matures on the exact same
date as the first bond, which has a 4-year life and is halfway done. The
second bond pays interest once a year on December 31, so it has two
more coupon payments. If this second bond has its coupon rate set at
the market rate, and the market rate is 7 percent at the time, this bond
11
50,000 / 1.03 + $50,000 / 1.032 + $1 million / 1.032 = $1.038 million.
12
50,000 / 1.07 + $50,000 / 1.072 + $1 million / 1.072 = $0.964 million.
126 ACCOUNTING FOR FUN AND PROFIT
Which bond has a higher net present value (NPV) (which bond would
you rather own): The one paying $50,000 a year for the next 2 years plus $1
million at the end, or the one paying $70,000 a year for the next 2 years plus
$1 million at the end? The latter is worth $1 million ($70,000 / 1.07 +
$1,070,000 / 1.072). The first bond is worth less: As computed above, it
is worth $964,000 ($50,000 / 1.07 + $1,050,000 / 1.072).
Note, the $36,000 difference in the PVs ($1,000,000 − $964,000)
can also be calculated by discounting the $20,000 difference ($70,000 −
$50,000) in the PV of the two coupon payments at 7 percent.
Long-Term Debt
1
US government bonds have durations from 90 days (for a U.S. Treasury bill), to
10 years (for a U.S. Treasury note), to 30 years (for a U.S. Treasury bond).
2
Other organizations issuing 100-year bonds such as Coca-Cola, Federal Express,
Ford Motor, and several universities, including Tufts University and MIT. There have
also been 1,000-year bonds issued, and the UK government issued bonds with no
maturity date called Consuls, which basically make interest payments forever (and
are thus called perpetuals). Almost anything can be included into a bond contract.
For example, the All England Tennis Club, where the Grand Slam Wimbledon
tennis matches are played, has issued bonds which give the bondholders tickets to
Wimbledon tennis matches.
128 ACCOUNTING FOR FUN AND PROFIT
3
Many years ago, bonds had detachable coupons: Parts of the bond would be liter-
ally cut from the actual hard copy of the bond, with an amount and a date written
on it. The coupon would be submitted to the issuing firm on or after the date on
the coupon, and the firm would then pay the amount of the coupon. Modern
bonds no longer have coupons that literally detach and funds are nowadays nor-
mally transferred electronically to the registered owner of the bond; however, the
term “detachable coupon” or “coupon” remains to describe the periodic interest
payments.
Long-Term Debt 129
equates the price of the bond with all future payments (coupons and face
value). Note that the coupon rate (or coupon) does not change over the
life of the bond: It is a contractual rate set in the bond indenture. By con-
trast, the discount rate (i.e., yield, effective rate, or market rate) changes
because of changes in the economy (e.g., as government interest rates rise
or fall, so will the firm’s discount rate) as well as changes in the market’s
perception of the firm’s risk level (e.g., the likelihood that all of the pay-
ments related to the bond will be made). As the discount rate changes, so
will the price of the bond (as explained in the bond valuation section in
Chapter 8).
Covenants are restrictions placed on the issuer/borrower that, if vi-
olated, allow the bondholder to demand immediate repayment of the
bond. They can be set as actions the borrower is not allowed to undertake
(e.g., paying dividends above a certain amount of earnings, limiting ad-
ditional debt, prohibiting senior debt), actions the borrower must take
(e.g., providing annual audited statements to the bondholders or their
agent), or creating some prescribed standard the borrower must meet
(e.g., maintaining a set ratio such as current assets to current liabilities of
1.5 or more).4
Security or collateral represents specific assets pledged to the bonds
if the company cannot repay its obligation.5 That is, if a firm does not
meet any of the terms of the bond (e.g., fails to make a coupon pay-
ment or violates a covenant), the bondholder can demand immediate
payment of the bond’s face value. If the firm is unable to pay (which
is likely if the firm missed a coupon payment), the bondholder can
take possession of the security and sell it to obtain repayment. If the
funds from the sale are greater than the amount owed, the balance is
4
Almost anything can be written into the bond contract. For example, bonds may
contain a provision saying that the bondholder can demand repayment if there is a
hostile, or any, takeover of the firm. If a bond has few or no covenants it is referred to
as “covenant light.”
5
The security or collateral does not have to be a physical asset. In 1997, the singer
David Bowie issued $55 million of 10-year bonds where the collateral was the
royalties from certain songs of his. The bonds were dubbed Bowie Bonds by Wall
Street.
130 ACCOUNTING FOR FUN AND PROFIT
returned to the firm. If the funds from the sale are less than the amount
owed, the bondholder has an unsecured claim (along with all other
unsecured claimants) on all of the firm’s other assets. Note that bonds
can be secured or unsecured. Bonds that are unsecured are also called
debentures.6
Priority of claims or payments. Whether secured or unsecured,
bonds can specify a priority of payment in the event of liquidation or
bankruptcy. Senior debt (first priority) is paid before junior debt (sec-
ond priority). Priority exists by default between secured and unsecured
bonds, because secured bonds have collateral that is handed over to
bondholders. But priority can be explicitly laid out within secured and
unsecured bonds as well (e.g., senior and junior secured, senior and
junior unsecured).
Redeemable bonds contain a feature that provides the bondholder the
option to exchange the bond for a preset value (often at a slight discount
to the face value) prior to the final maturity of the bond. A single bond
can have multiple dates at which bondholders are able to exchange their
bonds and can have different values for each date. However, most bonds
are nonredeemable.
Callable bonds contain a feature that provides the issuer the option to
pay off the debt at a preset price (often at a slight premium over the face
value) prior to the final maturity of the bond. As noted above, Disney’s
100-year “Sleeping Beauty” bonds have a 30-year call feature. Disney re-
served the right to buy back the bonds (i.e., force the bondholders to sell
them back to Disney) after 30 years.
Convertible bonds contain a feature that allows the bondholder to
exchange the bond into shares of the firm’s equity at a set rate(s) on a
specific date(s). For example, let us say a bond with a face value of $1,000
is exchangeable into 50 shares of common stock on July 1, 2018. Let
6
Although the term debenture means an unsecured bond, whether the bond actu-
ally has security or not depends on the indenture. Your author has seen “secured
debentures,” which indicates the lawyer drafting the indenture wanted to use a more
grandiose term than bond and apparently did not know that the word debenture
means unsecured bond.
Long-Term Debt 131
us also say the market price of the 50 shares on July 1, 2018, is above
the price of the bond (remember, the price of the bond is the PV of the
future coupon payments and face value). The bondholder has an incen-
tive to swap his convertible bond for the shares. There are numerous
variants of this theme (i.e., the bonds can have a call feature where the
firm can force the bondholders to convert to equity at a specific date).
The conversion features allow the bondholder to gain if the firm’s stock
price rises dramatically. In return for this option, the bond has a lower
coupon rate. This can be attractive for high-risk firms, as they would
otherwise have to offer high coupon rates. The majority of bonds issued
are nonconvertible.
Bond Ratings
There are companies that provide their opinions on the likelihood
that a firm’s debt will be repaid. These opinions are given in the form
of a rating or score. In the United States, there are three major firms
that do this. Standard and Poor’s (S&P) and Moody’s dominate the
market, followed by Fitch Ratings (Fitch). Each firm has a slightly dif-
ferent rating system. For example, S&P (and Fitch) has its best rating
as AAA followed by AA+, AA, AA−, A+, and so on. By contrast,
Moody’s top rating is Aaa, followed by Aa1, Aa2, Aa3, A1, and so
on. Exhibit 9.1 provides a description of various ratings for S&P. It is
important to note that the issuing firm pays the rating agencies, which
only issue an opinion (like the audit report) but, by government fiat,
cannot be sued for issuing incorrect or misleading opinions (unlike
the auditors). As such, and because rating agencies have proven un-
reliable in the past, your author suggests they are of dubious value
to investors.7 The ratings become important because various financial
institutions (e.g., banks, insurance companies, and pension plans) are
required by law to hold only securities rated BBB (called “investment
7
Prior to the financial crisis of 2009, these agencies were rating numerous securities
as AAA, which proved to be next to worthless (in fact, at the time, even without
hindsight, any reasonable examination should have led to ratings well below BBB).
132 ACCOUNTING FOR FUN AND PROFIT
Exhibit 9.1
Example of S&P long-term credit ratings
AAA Extremely strong capacity to meet
financial obligations
AA Very strong ... differs from AAA only by a small degree
A Strong ... more susceptible to adverse effects of changes
BBB Adequate capacity (BBB and above are called “investment
grade”). Below BBB are regarded as having significant
speculative characteristics
BB Less vulnerable in the near term than those below
B Current capacity to meet obligations but more
vulnerable
CCC Currently vulnerable
CC Highly vulnerable
C Currently highly vulnerable (bankruptcy may have been
filed)
R Under regulatory supervision
SD Selective default, likely to continue paying some debt
D Default
NR Not rated
grade”) and above. Thus, the government has created a market for
these ratings.
Using entries:
The last three entries are repeated in 2016 and 2017, with one final
entry at the end of the bond’s 3-year life:
What if the bond is repurchased prior to its maturity date at a value dif-
ferent from its accounting (book) value? There will be a gain or loss on the
134 ACCOUNTING FOR FUN AND PROFIT
repurchase. For example: What is the accounting entry if the bond was
purchased on January 1, 2017, for $1,009,637?8 It is:
1/1/2017 Bond payable $1,000,000
Loss on repurchase of bond $ 9,637
Cash $1,009,637
8
As explained in Chapter 8, this would be the bond price if the yield fell to 5 percent
compounded semiannually ($30,000 / 1.025 + $1,030,000 / 1.0252).
9
This would be the bond price if the yield increased to 7 percent compounded semian-
nually ($30,000 / 1.035 + $1,030,000 / 1.0352).
Long-Term Debt 135
10
As explained in Chapter 8, this is simply $1 million × 1.036 = $1,194,052. Also,
note that coupon payments do not compound (do not pay interest on interest).
The coupon is a payment that would have to be reinvested. By contrast, the inter-
est on a zero-coupon bond does compound as it is not paid until the end of the
bond’s life.
136 ACCOUNTING FOR FUN AND PROFIT
Amortization table:
Debt start Interest Subtotal Payment Debt down
$1,000,000 $30,000 $1,030,000 $184,598 $154,598
$ 845,402 $25,362 $ 870,764 $184,598 $159,236
$ 686,166 $20,585 $ 706,751 $184,598 $164,013
$ 522,153 $15,665 $ 537,818 $184,598 $168,933
$ 353,220 $10,597 $ 363,816 $184,598 $174,001
$ 179,219 $ 5,379 $ 184,595 $184,598 $179,219
Let us compare across the three different types of bonds. In the regular
bond example, the interest expense stayed the same over time because
the amount of debt borrowed stayed constant (as the interest was always
being fully paid). In the zero-coupon bond example, the interest expense
increased over time as the debt increased with the compounded interest.
In the mortgage bond example, the interest expense falls over time because
the debt is being reduced (at increasing amounts) with each payment.
Differences in interest expense across the three types of bonds:12
12
Remember, the interest expense and the payment do not have to be the same.
138 ACCOUNTING FOR FUN AND PROFIT
NPV = $1,027,541
Using a spreadsheet:
Time Payment PV factor Pmt / PV
1 $ 30,000 1.025 $ 29,268
2 $ 30,000 1.05063 $ 28,554
3 $ 30,000 1.07689 $ 27,858
4 $ 30,000 1.10381 $ 27,179
5 $ 30,000 1.13141 $ 26,516
6 $ 30,000 1.15969 $ 25,869
6 $1,000,000 1.15969 $ 862,297
13
The 5 percent semiannual yield is on the issue date and will change over time.
Long-Term Debt 139
The accounting entry for the bond at the date of issue could be simply:
Note that on the Balance Sheet, the liabilities would be the net bond
payable (the bond payable plus the premium or less the discount).
The discount or premium is then amortized (reduced to zero) over the
life of the bond. Many years ago, prior to personal computers, it was com-
mon to amortize using a “straight-line method” by dividing the discount
or premium by the number of payments (in this case, it would have been
the $27,541 premium divided by the six payments in the 3-year life of
the bond = $4,590). Interest expense would have been the cash payment
less the straight-line amortization amount in the case of a premium, or
the cash payment plus the straight-line amount in the case of a discount.
Thus, the periodic entry for each interest payment would have been as
follows:
6/30/2015 Interest expense $25,410
Premium on bond $ 4,590
Cash $30,000
time an interest payment (cash down) were made and prompted an inter-
est expense to be recorded.
Today the premium or discount must be amortized using what is
called the “effective rate method.” Here, the yield at the date of issue is
applied on the net Balance Sheet amount (which means bond payable less
the discount or plus the premium) to obtain the interest expense. Then
the difference between the interest expense and cash is the amortization
on the discount or premium. Following today’s practices, the first entry
in our example would be as follows:
The interest expense will thus decrease over time with a premium
or increase over time with a discount. As the premium (discount) is
reduced to zero, the interest expense declines (increases) because the
rate times the face value plus (minus) the declining premium (declining
discount). The amortization table that follows shows how the amounts
change for the example:
Note that, in the example, the interest expense is always 2.5 percent
times the net amount owed. After the final payment, the discount or
premium on the bond has been reduced to zero. On the last day, the face
value ($1 million) is paid and the debt is removed.
Long-Term Debt 141
Disclosures
When long-term debt matures in the coming year, the amount is reclassi-
fied to current liabilities under the caption “current portion of long-term
debt.” However, normally the entire amount is still also shown as long
term, less the current portion, for a net amount.
Current liabilities:
Current portion of long-term debt B
Long-term liabilities:
Long-term debt A
Less current portion of long-term debt B
Net long-term debt A−B
Owners’ Equity
Owners’ equity, funds given to the firm by its owners plus cumulated
earnings retained by the firm, is the final category in the Balance Sheet
equation:
Like many prior chapters, the owners’ equity chapter has lots of termi-
nology. However, once you understand the terminology, the accounting
choices explained in this chapter will hopefully feel straightforward.
Contributed Capital
The nature of a firm’s ownership and control is set out in its corporate
charter (or articles of incorporation), which in the United States is gov-
erned by state law. Corporations can incorporate in any state whether
they have business operations in the state or not. Most U.S. public firms
(over half of all public firms and 64 percent of the Standard and Poor’s
[S&P] 500 firms1) are incorporated in the State of Delaware that has
a court system (the Delaware Chancery) largely dedicated to corporate
matters and is viewed by many as corporate-friendly (in the sense of anti-
takeover, antilawsuits, and so on).
The first set of accounts in owners’ equity is called contributed capital.
As previously noted, contributed capital is the cumulative amount all the
individual owners have given to the firm. However, the firm’s accountants
1
As of September 2014. See http://technically/delaware/2014/09/23/why-delaware-
incorporation/.
144 ACCOUNTING FOR FUN AND PROFIT
usually break down this amount to provide more detail related to differ-
ent ownership terms.
The accountants state what type, or class, of shares the owners have.
A firm may have different types of ownership units but a corporation
must have at least one residual voting class of common shares (stock) rep-
resenting the owners’ investment in the firm and subordinate to all others.
It can also have what are called preferred (or preference) shares and there
can be additional classes within each of these categories.
The amount the owners give a firm for a particular class of share (i.e.,
the price the owners pay per share) can be broken into two categories:
“par value” (a notional value attached to the shares) and “additional
paid-in capital in excess of par value” (the difference between the total
amount the owners paid and the par value).2 Shares can also be issued as
non-par value, which means there is just the one category. Although there
are some technical legal issues concerning par value shares, the distinc-
tion between par value and contributed capital (par value plus additional
paid-in capital in excess of par) generally has no impact on the vast num-
ber of public firms and the users of their financial statements. For this
reason, many users (your author included) often sum the par value and
additional amount for each class of shares and simply have one line called
contributed capital for each class of shares in their spreadsheet.
Also, remember the amounts recorded are what the owners give the
firm for shares (that is why the item is called “contributed capital”). When
the shares are subsequently traded between members of the public, the
prices paid on the market have no effect on the firm or its financial state-
ments because the capital is being exchanged between shareholders and
not between a shareholder and the firm.
There are three nonfinancial amounts associated with shares:
2
The par value of shares is not analogous to the par value of bonds. Par value of shares
is, as noted, a fictional amount which bears no relationship to what the owners will
receive in the future.
Owners’ Equity 145
At the end of 2015, the Ford Motor Company had roughly 3,960 mil-
lion shares of Class A common stock and 71 million shares of Class
B common stock. In fact, the Class B shares had 40 percent of the
total votes (or roughly 37 votes per Class B share) despite the fact
that the Class B shares numbered only 1.8 percent of the total com-
mon shares. According to Ford’s 2015 Annual Report (Note 23, page
FS-58), “Holders of our [Class A] Common Stock have 60 percent of
the general voting power and holders of our Class B [Common] Stock
are entitled to such number of votes per share as would give them the
remaining 40 percent. Shares of [Class A] Common Stock and Class
B [Common] Stock share equally in dividends when and as paid, with
stock dividends payable in shares of stock of the class held.”
Why did the Ford Motor Company give some common shares a different
number of votes per share than it gave other common shares? The voting
structure was designed to give the Ford family control of the firm. The
Class B common shares could only be owned by an heir of Henry Ford.
In fact, the details of Ford’s Class B common shares are even more fun.
It seems Henry wanted to provide an incentive for the family to keep
their shares in the family. The Class B common shares voting power
drops from 40 to 30 percent (from 37 votes per share to 24 votes per
share) if the family’s holding falls below 60.7 million shares. Further-
more, if the family holdings fall below 33.7 million shares, then the
shares become normal common shares with one share one vote. More-
over, if a family member sells a Class B common share to a nonfamily
member, it becomes a Class A common share and can never revert back.
See http://beginnersinvest.about.com/od/stocksoptionswarrants/a/ford-
dual-class-stock.htm
146 ACCOUNTING FOR FUN AND PROFIT
shares, but there can be multiple classes having one vote per share or
having different numbers of votes per share. For example, there could be
three (or more) classes of common shares: Class A, nonvoting; Class B,
one share one vote; and Class C, with multiple votes per share.3
Preferred shares have, as their name suggests, a preference over the
common shares.4 What kinds of preference do preferred shares have? First,
the preferred shares are entitled to receive a dividend before any can
be paid to the common shares.5 Second, the dividend on the preferred
shares is often at a set amount (e.g., $1.00 per share) and can be ei-
ther cumulative or noncumulative—these shares are called “cumulative
preferred shares” and “noncumulative preferred shares.” The cumula-
tive feature is extremely important to the value of preferred shares. The
cumulative feature means that if the preferred shares do not receive a
dividend in a particular year, the amount accumulates to the next. For
example, if a cumulative preferred share with a $1.00 stated dividend is
not paid a dividend for 6 years, then in the seventh year, the preferred
shareholders would have to receive $7.00 before any dividends can be
paid to the common shareholders ($6.00 from accumulated dividends
of prior years plus $1.00 for the current year). If the preferred shares are
noncumulative, in the seventh year preferred shareholders would only
have to receive $1.00 per share before a dividend can be paid to the
common shareholders. Third, the preferred shares can have a convertible
feature allowing the holder to turn them in for a set number of common
shares. Fourth, the preferred shares may have a call feature, allowing
the firm to buy them back at a set price. Finally, they can be voting or
nonvoting.
3
There is even an idea to have “tenured” shares where the shares have more votes based
on the years they have been owned (one vote if owned less than a year, two votes if
owned for 2 years, and so on). See D.K. Berman. March 18, 2015. “Seeking a Cure
for Corporate Activism,” The Wall Street Journal, B1.
4
Note that in the United States, the words “shares” and “stock” are used interchange-
ably. In the UK, the word “stock” normally means inventory.
5
Remember, a firm does not have to pay a dividend. The dividends only become a
required payment if the board of directors declares them. Of course, the shareholders
have the power to vote in board members and thus, indirectly, generate the dividends
(e.g., by voting in people they believe will tend to have the firm pay dividends).
Owners’ Equity 147
Retained Earnings
As noted back in Chapter 3, retained earnings are the cumulative profit
or loss a firm has made from its inception to the date of the Balance Sheet
less any funds given to the owners, which are called dividends. Retained
earnings can be written as:
Profit and loss, as previously noted, are the closing (resetting to zero)
of the temporary revenue and expense accounts. Thus, the only new vari-
able here is dividends, which are the distribution of accumulated profits
to the owners.
Firms with excess cash (funds they do not need to maintain or grow
their business, acquire new businesses or pay down their debt) can return
these funds to the owners by paying dividends.
There are three important dates related to dividends:
6
Another discussed date is the “ex-dividend date.” This is usually two business days
before the record date. The seller of a stock on the ex-dividend date (rather than the
buyer) will receive the dividend.
148 ACCOUNTING FOR FUN AND PROFIT
The timing of these events must occur in this order (declaration, record,
and payment). However, the events can be on the same date, or two dates,
or three dates.
It is important to note that dividends can only be paid up to the
amount of retained earnings (dividends cannot be paid when retained
earnings are negative or in an amount that would cause retained earnings
to become negative). If the firm has no retained earnings (or has a deficit
with accumulated losses exceeding accumulated profits), it cannot legally
pay a dividend, and if it does, the directors become personally liable to
the firm’s creditors for the difference. However, it is possible for a firm to
pay a dividend when it has positive retained earnings but subsequently
lose money, causing retained earnings to become a deficit. It should also
be noted that dividend payments are “sticky.” Once a firm starts paying a
dividend, it is usually very reluctant to stop paying the dividend or even
decrease it because doing so normally causes a sharp decline in stock price.
Treasury Stock
Dividends are not the only method a firm has to provide funds to its own-
ers. An alternative method is for the firm to repurchase its own shares.
Share repurchases usually have lower tax rates for shareholders. So why
don’t firms use share repurchases instead of dividends? Primarily because the
International Revenue Service (IRS) will treat repurchases as dividends if
a firm does regular repurchases (e.g., every quarter). Share repurchases are
often done: (1) as part of a merger involving a stock swap, (2) to fend off a
hostile takeover, (3) to redeem stock options in share-based compensation
plans, or (4) to increase or stabilize earnings per share (the latter two are
discussed in more detail in Accounting for Fun and Profit: Understanding
Advanced Topics in Accounting).
There are three main ways firms repurchase their shares. One is open
market purchases, simply buying shares in the market like anyone else.
A second is called a fixed price tender. Here the firm publicly announces
details of the number of shares it hopes to buy and the set (fixed) price it
Owners’ Equity 149
will pay. The firm is then obligated to buy at least the minimum number
to which it committed, but it can buy more. Finally, firms can also repur-
chase their shares using what is called a “Dutch auction tender.” Here the
firm sets the number of shares but not the price per share, or the firm sets
the price per share but not the number of shares it will purchase.7
Regardless of how a firm repurchases its shares, there is NEVER a gain
or loss on the repurchase of a firm’s own shares. This differs from a firm’s ac-
counting of marketable securities, where the firm reports a gain or loss on its
investment. When buying back its own shares, the firm records a decrease in
cash and a decrease in either contributed capital (if the firm retires the shares)
or an increase in account called “treasury stock”—in either case, owners’ eq-
uity is reduced. (Treasury stock is a contra or negative equity account that
reduces owners’ equity. If treasury stock increases, it means that the firm has
decided not to retire the shares and can reissue them in the future.)
If at some future point, the firm decides to issue additional shares,
and it has both unissued shares (authorized shares that have never been
issued) and treasury stock (once issued shares that were repurchased), it
can issue either. Basically, cash increases and either contributed capital
increases or treasury stock decreases. There are some additional details
on how this is done, but it generally does not impact the outside user of
financial statements.
7
Most, but not all, countries allow firms to repurchase their own shares. Additional
details on why and how a firm repurchases its own shares are beyond the scope of this
book but available in most finance textbooks.
150 ACCOUNTING FOR FUN AND PROFIT
8
See http://blogs.wsj.com/moneybeat/2014/04/23/apples-7-for-1-stock-split-is-very-
unusual/ (viewed November 23, 2015).
9
Alternatively, adjusting for the splits, each of the 57 shares cost only $0.39 ($22 / 57).
CHAPTER 11
Cash Is King
Cash Flows
How can a firm obtain cash? Four ways:
1
There may be some minor discrepancies if a firm has different currencies, but for now
we ignore this complexity.
154 ACCOUNTING FOR FUN AND PROFIT
As an outside investor looking at a firm, how would you rank these four pos-
sibilities in terms of attractiveness? Finance tells us there is a “pecking order”
for the ways of obtaining cash. Internally generated funds are preferred
over borrowing, which is preferred over equity issues. This means collect-
ing from customers after selling products or services (and hopefully selling
them for more than they cost to produce) would be a firm’s preferred source
of cash. Empirical research in finance tells us there is little or no stock
market reaction when firms borrow funds (so this would be second), but
there is often a negative stock market reaction (share price falls) when a firm
issues new equity (making this number three). Selling long-term assets is
fine if the resources sold are not needed, otherwise this is the least favorable
alternative as it means the firm is either desperate and/or liquidating.
What does a firm use cash for? Again, there are four categories:
Here the ranking is not quite as clear. Many firms like to delay paying
suppliers because they believe this is free financing. Lenders have to be
paid when funds are due, but this can be negotiated. Some owners want
cash distributions while others prefer to have the firm continue to invest
its funds. And, clearly, if a firm has financially attractive projects to invest
in, then the purchase of long-term assets is a good thing.
However, regardless of how one ranks these different cash inflows and
outflows, it is clear that an outsider should find it informative to not
only know the total cash flows in and out of the firm but also have them
categorized. The cash flow statement is categorized in the following ways:
lower than the cash paid to suppliers. This is because if sales are increas-
ing rapidly, the firm has to fund receivables and inventory. Payables are
also likely to increase, but the total increase in payables will probably be
less than the total increase in receivables and inventory. Hence, the firm
will have a negative cash flow from operations, which means working
capital (accounts receivables plus inventory less account payable) is flat or
decreasing. By contrast, Firm B is stable and Firm C is declining, so when
it comes to cash from operations, we expect these firms to collect more
than they are paying.
What about cash from investing? This should be the same as cash from
operations for Firms A and C. We would expect Firm A to be investing
in new plant and equipment (cash outflows), whereas Firm C is divest-
ing (cash inflows). Firm B is stable, so it is unclear whether it will grow
slightly, continue to be stable, or shrink slightly.
And what about cash from financing? This is likely to be the op-
posite of cash from operations. A firm must finance any net decrease
in cash from operations and investing. This means Firm A will have
to borrow funds and/or issue new equity to obtain funds because
the cash it is getting from operations does not cover the cost of the
operations (negative cash from operations). By contrast, Firm C is
expected to have excess cash from operations and investing, so it can
pay down debt and/or return cash to the owners. Firm B is stable or
in steady state, so its financing could be slightly positive, or slightly
negative.
Thus, our expectations (and the above is far from complete) of where
cash flows come from and where it goes depends, at least to some extent,
on a firm’s economic life cycle. It is a diagnostic, similar to a doctor tak-
ing someone’s blood pressure. Most medical exams begin with taking an
individual’s blood pressure because it is used as a diagnostic to determine
the subsequent exam.
In addition, cash flows will not always meet expectations, and when
they do not meet expectations, the reader should endeavor to understand
the cause of the difference from expectations. The explanation helps the
reader to understand the firm’s business model.
Cash Is King 157
2
Firms are allowed to provide the cash collected from customers and cash paid to sup-
pliers in addition to the net income to cash from operations reconciliation. Additional
information is always allowed.
158 ACCOUNTING FOR FUN AND PROFIT
The Balance Sheet provides the opening and closing amounts for re-
ceivables, and the Income Statement provides the sales. We solve for cash
collections using simple algebra:
Next, we find the amount actually paid by using the formula for
year-end payables:
What are the implications of one of the variables changing, like payables or
inventory? Holding inventory constant means purchases = cost of goods sold
(essentially, newly purchased inventory exactly replaces the inventory that is
sold during the year). Holding payables constant means the firm pays for
exactly what was purchased. Holding both inventory and payables constant
means the firm paid for cost of goods sold (or cash out = cost of goods sold).
What happens if inventory changes but payables do not? Holding pay-
ables constant: If inventory increases, it means the firm has purchased and
paid more than cost of goods sold. If inventory decreases, it means the
firm has purchased and paid less than cost of goods sold.
What if payables change but inventory does not? If payables increase,
it means the firm has paid less than the cost of goods sold (more unpaid
bills means less cash out). If payables decrease, it means the firm has paid
more than cost of goods sold (less unpaid bills means more cash out).
And what if both inventory and payables change?
Are we done? Not quite. Changes in other current assets (e.g., prepaid
expenses) and other current liabilities (e.g., accrued expenses) indicate
that there are expenses recorded on the Income Statement that are not
160 ACCOUNTING FOR FUN AND PROFIT
equal to cash paid. In this case, an adjustment similar to the one made
for cost of goods sold is required (the adjustment taking payables into ac-
count) as shown in the next section.
An Illustration
Exhibits 11.1 and 11.2 present a simple Balance Sheet and Income Statement.
Exhibit 11.1
Balance Sheet and changes
End Year 1 End Year 2 Change
Cash 100 110 10
Receivables 200 240 40
Inventory 300 350 50
Prepaid expenses 50 40 (10)
Property, plant, and equipment 500 640 140
Accumulated depreciation (200) (240) (40)
Total assets 950 1,140 190
Exhibit 11.2
Income Statement for Year 2
Sales 800
Cost of goods sold 500
Gross profit 300
Depreciation expense 50
All other expenses 180
Operating profit 70
Gain on sale of PP&E 12
Net profit (for simplicity assume no taxes) 82
Cash Is King 161
Why is depreciation ignored in the above calculation? Because it did not in-
volve an outlay of cash. Likewise, the gain on sale of property, plant, and
equipment (PP&E) is ignored as it also did not involve any cash. Wait
a minute. If PP&E was sold, would there not be some cash received? Yes,
but the cash received, all of it, is included under cash from investments.
Remember, the Cash Flow Statement cares only about cash transactions,
whereas the Income Statement includes noncash items (such as deprecia-
tion expense and gains on sale of PP&E).
The above is the direct computation of cash from operations. How-
ever, as noted, what is normally presented in a Cash Flow Statement is an
indirect computation that shows how to reconcile (adjust) net income to
cash from operations. This would be done as follows:
Net income $ 82
Plus depreciation (this is a noncash expense) $50
Less the gain (plus a loss) on sale of PP&E (this is a ($12)
noncash revenue)
Less the increase (plus a decrease) in receivables ($40)
Less the increase (plus a decrease) in inventory ($50)
Plus the decrease (less an increase) in prepaid expenses $10
Plus the increase (less a decrease) in payables $30
Less the decrease (plus an increase) in accrued expenses ($15)
Net change ($ 27)
Cash from operations $ 55
Note that cash from operations is the same number under both the
presentations above. It has to be. If it is not, it means . . . you have made
a mistake! That is the beauty of accounting.
Both methods result in the same cash from operations, and firms can
elect either approach. Arguably, the indirect method is preferred because it
162 ACCOUNTING FOR FUN AND PROFIT
provides the link between net income and cash from operations. However,
if a firm chooses the direct method, it must also provide a supplemental
presentation of using the indirect method. By contrast, if a firm chooses
the indirect method, it is not required to provide supplemental informa-
tion using the direct method (i.e., it is one and done). Thus, it may not be
surprising that the vast majority of public firms elect the indirect method.
Using our illustration above: Were any assets sold? Yes. How do we know?
This would be information a firm would already have. However, outsid-
ers might find this information in the Notes to the Financial Statements
or perhaps with a gain or loss on the sale of PP&E being itemized on the
Income Statement, as in our current example with Exhibit 11.2. (If there
is a gain or loss on the sale, it means something was sold.) Additionally,
we can use the algebraic equations for PP&E and its accumulated depre-
ciation accounts to determine if anything was purchased or sold.
1. The equation to calculate the year-end value of PP&E for the Bal-
ance Sheet:
Inputting the numbers found in Exhibits 11.1 and 11.2 gives us:
and
The PP&E formula (i.e., what happens to the PP&E account from
the start of the year to the end of the year) shows us whether something
was purchased: PP&E increases from $500 at the start of the year to
$640 at the end, so clearly something was purchased (it could not have
increased if there was only a disposal). By itself (without additional in-
formation as discussed below), the equation does not provide the cost of
assets sold or purchased.
The accumulated depreciation formula gives evidence of whether any-
thing was sold. If nothing was sold (or the item sold had no accumulated
depreciation), then the accumulated depreciation account would increase
by exactly the depreciation expense. Here accumulated depreciation in-
creases by $10 less than depreciation expense (depreciation expense was
$50 but accumulated depreciation increased by $40). This means the
item sold had accumulated depreciation of $10.
Besides using the equations above, we can determine if something was
sold by looking at the Income Statement: If the Income Statement lists
a gain or loss on the sale of PP&E, it means something must have been
164 ACCOUNTING FOR FUN AND PROFIT
sold. However, if there is no gain or loss, it could be that the item was
sold for book value or that the gain or loss was small and combined with
another amount when listed on the Income Statement. Thus, knowing
how to use the equations above is still important.
The two equations above tell us whether a long-term asset was sold or
purchased and the amount of accumulated depreciation on assets sold.
However, to determine the cost of PP&E sold requires additional infor-
mation on the amount paid for PP&E during the year, which should be
available in the Notes to the Financial Statements.
Once the cost of PP&E is computed, the cash received from the sale
of PP&E is determined by adding a gain or subtracting a loss from the net
book value (the cost of PP&E sold minus the accumulated depreciation on
PP&E sold). For example, assume the Notes to the Financial Statements
indicate the firm purchased new PP&E for $300. This means the origi-
nal cost of the PP&E sold was $160 (PP&Estart + purchases of PP&E −
PP&Eend = $500 + $300 − $640 = cost of PP&E sold). We have already
computed the accumulated depreciation on the asset(s) sold as $10. This
means the net book value (cost − accumulated depreciation) of the PP&E
sold was $150. The gain on the sale as listed on the Income Statement was
$12.3 Thus, the cash received was $162 ($150 + $12), using the logic that:
Cash received from sale = net book value of asset + gain from sale
(or − loss from sale)
3
Note, the gain on the sale of PP&E is not an amount above the original cost of the
PP&E. Rather, the gain is the difference between the cash received and the net book
value (cost less accumulated depreciation) of the asset.
Cash Is King 165
We can now prepare the cash from investing section of the Cash Flow
Statement:
Note that in the example above, the amount shown is the net cash
from issuing new debt and the net cash from issuing new equity. In fact,
the amounts should be separated (as shown at the start of this chapter)
into cash paid to retire debt and cash received from new debt as well as
cash paid to repurchase shares and cash received from issuing new shares.
As with PP&E, these specifics can be computed only with additional in-
formation (ignored here for simplicity).
To compute the cash dividends paid, we return to the algebra of the
retained earnings account:
166 ACCOUNTING FOR FUN AND PROFIT
Once again, the math works (if it does not, it means there is a mistake).
How could this Cash Flow Statement be interpreted? Perhaps this is
an established firm, which is still growing. The firm is throwing off
cash from operations but not enough to finance its new investment in
PP&E, so the firm still has to obtain funds from debt and equity. With-
out the new investment in PP&E (net PP&E is substantially more than
the depreciation expense, reflecting a growing firm), the firm would
have enough cash from operations to pay all its dividends and still pay
down some debt or buy back some shares. Because the firm does not
have enough cash from operations to fund the new PP&E and still
chooses to pay dividends, it requires even more financing than it would
otherwise.
4
An even worse approximation for free cash flow is net income plus depreciation (this
crude estimate is often referred to as a “banker’s free cash flow”).
Cash Is King 169
Combined with the other statements, understanding the cash flows pro-
vides an additional tool in understanding the economics of a firm.
The next chapter begins to bring all the numbers together using ratio
analysis as a starting point to diagnose a firm’s health and determine its
key economic drivers. It ends this volume. But first, Appendix 11A pres-
ents a simplified method for an outsider to produce cash flow statements.
APPENDIX 11A
If you are comfortable with debits and credits, the Cash Flow Statement
can be prepared by creating T accounts for all Balance Sheet items and
adjusting all changes to the cash account.5 This is done by creating a
large T account for cash divided into three sections (Operations, Invest-
ing, and Financing) and smaller T accounts for everything else. Then,
for each change (debit or credit) required to adjust each account (other
than cash) from its opening to closing balance, a corresponding opposite
change (credit or debit) is made into the large cash T account. Let us do
this for our example above.
For each small T account below, the opening and closing numbers are
in bold and the required entry to balance the specific account is in ital-
ics. Whatever entry is required in the small T account to balance (a debit
or credit), the opposite entry (a credit or debit) is made in the large cash
T account below. The entries are numbered in parentheses to help you
match them with the numbers in the cash T account. Underneath each
small T account is also a written description of the impact to the small T
account and cash.
5
This can also be done on a spreadsheet with plusses and minuses, but using debits
and credits can reduce mistakes.
APPENDIX
171
(Note that CA stands for current assets, CL for current liabilities, and
Divd. for dividends.)
172 APPENDIX
The opposite of each adjustment (in italics above) is then entered into the
cash T account below.
Cash
Open $100 |
|
Net income (11) $82 |
Depreciation (6) $50 |
Loss PP&E n/a | Gain PP&E $12 (5)
Decrease receivable n/a | Increase receivable $40 (1)
Decrease inventory n/a | Increase inventory $50 (2)
Decrease other CA (3) $10 | Increase other CA n/a
Increase payables (7) $30 | Decrease payables n/a
Increase other CL n/a | Decrease other CL $15 (8)
Cash from operations $55 | Cash from operations
|
Cash from sale of PP&E (5) $162 | Cash from purchase of PP&E $300 (4)
Cash from investments | Cash from investments $138
|
Cash from debt (9) $125 | Cash paid to retire debt n/a
Cash from new equity (10) $ 10 | Cash paid to retire equity n/a
| Cash dividends paid $42 (12)
Cash from financing $ 93 | Cash from financing
still increased by $125, it means there was $200 in new debt issued
(opening balance of $200 + new debt of $200 2 debt retired of $75
= ending balance of $325).
(10) Contributed capital has an opening credit balance of $300 and a
closing credit balance of $310. This means the account had net new
equity issued (a credit) of $10 (i.e., cash up net $10, contributed
capital up net $10). As with long-term debt, if some equity was re-
purchased but the ending balance remained the same, it means more
new equity had been issued. Assuming no equity was repurchased,
the net increase in cash from financing is (debited) $10.
(11) Retained earnings have an opening credit balance of $50 and a clos-
ing credit balance of $90. We see that the account increases (a credit)
by the net income of $82. The corresponding amount (debit) is in
cash from operations.
(12) Finally, we note that opening retained earnings plus net income is
more than ending retained earnings. This means that a dividend was
paid (a debit in the retained earnings account). The amount required
to balance is $42. In the cash T account, this is a credit to cash from
financing.
CHAPTER 12
1
Equity Funding filed for bankruptcy on March 30, 1973, at a time when the media
was fixated on the Watergate scandal involving President Richard Nixon (Nixon tried to
cover up a break-in to the offices of the Democratic National Committee at the Water-
gate office complex in the District of Columbia, ordered by members of his staff). The
break-in occurred on June 17, 1972. On April 30, 1973, President Nixon asked for the
resignation of his top two aids. President Nixon himself resigned on August 8, 1974.
178 ACCOUNTING FOR FUN AND PROFIT
Oil Swindle of 1963, the Allied Crude Vegetable Oil Refining Company
(Allied) claimed sales of $250 million, which represented 75 percent of
total U.S. exports of cottonseed and soybean oil. Allied leased approxi-
mately 100 tanks to store the oil, with a total capacity of about 500 mil-
lion pounds of vegetable oil, yet the firm claimed to have 1.8 billion
pounds of oil in inventory. At the time, the United States exported about
1.2 billion pounds a year. Thus, Allied’s 1.8 billion pounds represented
1.5 times the total U.S. annual exports. Did it made sense for this one firm
to have that quantity of inventory? Definitely not. When Allied filed for
bankruptcy on November 19, 1963, the firm had only about 100 million
pounds of various substances in the tanks (mostly water and sludge, not
oil). Allied’s $100 million purported worth of vegetable oil turned out to
be, in reality, a mere $6 million worth.2
Profitability
Imagine two firms, one having a net profit of $5 million and the other
having a net profit of $40 million. Which firm has done better? Clearly the
second firm has earned more, but the profits do not tell the whole story.
For example, if the first firm earned the $5 million with an investment of
2
The Allied Vegetable bankruptcy filing on November 19, 1963, was overshadowed by
President John F. Kennedy’s assassination on November 23, 1963.
Financial Statement Analysis 179
$25 million (a 20 percent return), whereas the second firm earned $40
million on an investment of $400 million (a 10 percent return), we might
feel the first firm did better. In other words, there is more to determining
a firm’s profitability than just looking at the total profit earned.
There are three main types of profitability ratios, of which profit di-
vided by amount invested as noted above is just one:
Profit margins. This ratio essentially measures the return, or profit, on
a dollar of sales revenue. It can be computed for various levels of profit
(e.g., gross profit, operating profit, net profit, and so on). The numerator
is the profit number, the denominator is the sales number.
Return on Assets (ROA) looks at the profit given the total resources
available, independent of how the resources were financed. The numera-
tor is net profit adjusted for the cost of financing net of any tax effects.
The denominator is the total resources available.
ROA = (Net Income + Interest Expense (1 − the tax rate)) / Total Assets
To explain a bit more: Imagine you have two firms, both earning
$100 million before finance charges and taxes. The first firm has financed
the resources entirely with equity. The second firm has financed with both
debt and equity, and has an annual interest charge of $20 million. If the
corporate tax rate is 30 percent, the first firm will have net profit of $70
million, whereas the second firm will have net profit of $56 million.
Firm A Firm B
Profit before interest and taxes $100 $100
Interest expense $ 0 $ 20
Profit before taxes $100 $ 80
Taxes (30 percent of profit before taxes) $ 30 $ 24
Net profit $ 70 $ 56
are tax deductible. Essentially, the government shares the cost of financ-
ing by allowing the firm to reduce taxable income by the interest expense.
The government thus picks up $6 million of the total cost of financing
(which can be seen in the difference in the tax of the two firms, $30 million
vs. $24 million), and the true cost to Firm B of financing is $14 million,
or interest minus tax savings (calculated as the $20 million in interest × [1
− the tax rate]). We can make the two firms’ profits directly comparable
by adding back Firm B’s after-tax financing charge of $14 million.
Firm A Firm B
Profit before interest and taxes $100 $100
Interest expense $ 0 $ 20
Profit before taxes $100 $ 80
Taxes (30 percent of profit before taxes) $ 30 $ 24
Net profit $ 70 $ 56
Add back after tax cost of interest $ 0 $ 14 ($20 × 70%)
Adjusted profit ignoring cost of financing $ 70 $ 70
investing $1,000 in a bank account, earning $50, and ending the year with
$1,050 in the bank account. What is the return? It is not 4.88 percent ($50
/ $1,025), using the average of the two investment amounts. It is not 4.76
percent ($50 / $1,050), using the ending number. Rather, it is 5 percent
($50 / $1,000), using the initial investment or opening number.
Often year-end numbers are used because they are readily available
and being more precise would not result in a material difference (this is
true when the opening and closing numbers are not materially different).
Still, it is important to know and understand the choice used.
Appendix 12A provides selected financial information for Apple Inc.
along with calculations for the ratios discussed. As can be seen Apple
maintained a gross profit margin of about 40 percent and a profit mar-
gin of about 23 percent from 2012 through 2015. Thus, Apple gener-
ates $0.40 gross and $0.23 net per $1.00 of sales. Its return on assets
average 21 percent with ROE averaging 37 percent from 2013 to 2015
(note to calculate the 2012 ratios requires the opening Balance Sheet
numbers for 2012—which are the ending numbers for 2011). These are
extraordinarily high ratios for any firm and explain Apple’s high market
value.
Activity
Activity ratios focus on the firm’s operations. Below are a few possible
activity ratios:
The first three ratios reflect how well a firm is managing its collec-
tions and inventory and how long the firm is taking to pay its suppliers.
The last two indicate the amount of fixed assets (property, plant, and
equipment [PP&E]) and total assets the firm needs in order to gener-
ate sales. Changes in these last two ratios are often related to changes
in revenue.
182 ACCOUNTING FOR FUN AND PROFIT
Appendix 12A shows Apple’s ratios are consistent over the last few
years. Apple took 26 days to collect in 2015. This reflects the combina-
tion of sales to third party vendors (e.g., phone companies) as well as di-
rectly to consumers (whose payment with credit cards would be received
by Apple a day or two after the sale). Apple’s 2015 ratio of 6 days of
inventory reflects a very efficient operation. At the same time, Apple takes
115 days to pay its suppliers. Days receivable plus days inventory less days
payable is often referred to as net working capital. For most firms, net
working capital is a positive number reflecting the amount of financing
the firm requires for net working capital (days receivable plus days inven-
tory less days payable). For Apple, it is a negative number (26 days +
6 days − 92 days = −60 days). Thus, Apple is using its large purchasing
power to essential extract financing from its suppliers. Apple’s fixed asset
turnover of almost 11 indicates the firm does not require much PP&E for
operations. The total asset turnover is less the 1 because of the enormous
amount of cash and marketable securities held by Apple.
Leverage
Leverage measures how a firm has funded its resources: the split between
debt and equity. It is a measure of long-term risk. All else equal, the greater
the funding from debt, the greater the risk that the firm will be unable to
repay the debt and the greater the probability of bankruptcy.
Although there are many different ways to do the actual calculation,
there are really two key differences in how this risk is calculated. One set
of approaches counts only interest-bearing debt as debt (i.e., it excludes
accounts payable, deferred taxes, and other such liabilities), whereas the
other includes all liabilities as debt.
Note the second and third ratio above measure exactly the same
thing. The second ratio may be more intuitive, whereas the third fits into
Financial Statement Analysis 183
Liquidity
Liquidity is a measure of short-term risk. It considers whether the firm
has the ability to pay its current debts as they come due. The two key
liquidity ratios are:
Other Ratios
There are numerous other ratios that are used to measure specific areas of
a firm. For example, advertising expenses or research and development
expenses as a percentage of sales. These ratios indicate whether a firm is
184 ACCOUNTING FOR FUN AND PROFIT
trying to expand its market share and product line or perhaps is cutting
back to improve short-term profits (potentially at the cost of long-term
profitability).
Sales / Employees and Fixed Assets / Employees used to be very popu-
lar ratios. The idea was to measure the efficiency of employees (how much
sales each employee generated and how much fixed assets are required per
employee). Of course, a firm could improve these ratios by outsourcing,
which is why it is so important for the analyst to consider any substantial
change in the denominator and its cause.
DuPont Analysis
The DuPont Model3 says that a firm’s ROE is the product of its profit-
ability (selling stuff for more than it cost), its capital intensity (sell-
ing stuff without excess resources), and its financial leverage (financing
well). These are measured by Net Income / Sales, Sales / Assets, and
Assets / Equity, respectively. (Assets / Equity is the less-than-intuitive
leverage ratio introduced above, which you can now see fits nicely into
the DuPont formula). There are therefore three levers by which a firm
can increase ROE.
3
Named after the DuPont Corporation, which first started talking about this type of
analysis over a hundred years ago.
Financial Statement Analysis 185
DuPont Formula:
ROA = Net Income4 × Sales
Sales Total Assets
4
Note that net income really should be adjusted here for interest net of taxes, but this
is often not done in DuPont Analysis to facilitate the move from ROA to ROE. Also,
the figure for total assets in the asset turnover formula is often the year-end number so
it matches (and cancels out) the amount used in the leverage ratio.
APPENDIX 12A
Profitability
Sales growth (%) 27.9 7.0 9.2 44.6
Gross profit margin: gross 40.1 38.6 37.6 43.9
profit / sales (%)
Net profit margin: net 22.8 21.6 21.7 26.7
income / sales (%)
Return on assets: net 23.0 19.1 21.0 n/a
income / total assetsopen
(%)
ROE; net income / 47.9 32.0 31.3 n/a
equityopen (%)
Activity
Days receivable: 26.31 34.86 27.98 25.49
receivables / (sales / 365)
Days inventory: inventory 6.12 6.86 6.04 3.29
/ (COGS / 365)
Days payable: payables / 92.31 97.88 75.89 n/a
(purchases / 365)
Fixed asset turns: sales / 10.85 9.82 10.67 n/a
PP&Eaverage
Total asset turns: sales / 0.89 0.83 0.89 n/a
total assetsaverage
Leverage
Debt: debt / (debt + 35.1 24.0 12.1 0.0
equity) (%)
Leverage: total assets / 243.4 207.8 167.5 148.9
equity (%)
Liquidity
Current: current assets / 110.9 108.0 167.9 149.6
current liabilities (%)
Quick: quick assets / 72.5 67.0 122.9 103.9
current liabilities (%)
Index
Accounting Balance sheet, 15–21, 28–31
accrual basis of, 49–58 assets, 28
cash basis of, 21, 50 and income statement, 41–44
for current liabilities, 97 liabilities, 29
description of, 1 owners’ equity, 29, 143–151
economic concept of, 21 presentation of, 29–30
information, 1 spreadsheet, 47
introduction to, 1–13 Bank debt, 97–98
for payables, 98 Bonds, 127
process of, 27–44 accounting for, 132–135
system, 1, 41 callable, 130
traditional methods, 17–20 convertible, 130–131
Accounts receivable, 63–64 ratings, 131–132
aged, 71–74 redeemable, 130
Accounts payable, 35, 98 serial bond (mortgage), 136
description of, 35 terms of, 127–128
Accrual accounting, 49–58 valuation, 122–126
expense, recognition of, 54–56 zero-coupon, 135
revenue, recognition of, 50–54 Bookkeeping, 27
Accrued expenses, 109
Accumulated depreciation, 94 Callable bonds, 130
Activity ratios, 181–182 Cash, 59–61, 153–175
Advances, 99 accounting, 21
Adverse opinion, 12 from financing, 165–166
Aged accounts receivable, 71–74 from investing, 162–165
Amortization, 96 obtaining, 153–154
Annual depreciation, 89 from operations, 157–162
Annual percentage rate (APR), 116 used for, 154
Annual report, 2 Cash flow statements, 170–175
covers of, 6 categorizing, 154–155
and customers, 4 Common size financial statements, 184
and government, 4 Compound entry, 45
inside of, 8–12 Compounding, 111, 113–115
opinions and, 9–12 Contract rate, 128
order of, 12–13 Contributed capital, 143–146
purpose of, 3 Convertible bonds, 130
reading of, 13 Corporate bonds, 127
and senior management, 3–4 Coupon rate, 122, 128
Annuities, 116–122 Coupons, 122
Annuity due, 119–122 Covenants, 129
Assets, 15–22, 28 Credit, description of, 31
AVG, 17–18, 20 Cumulative preferred shares, 146
190 INDEX
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