1.

FINANCIAL ACCOUNTING-COURSE TRAILER

Have you ever been in a meeting or a discussion with colleagues when someone starts
talking finance and you find yourself quickly losing interest because you can't really
follow the conversation? Let's face it, the accountants and finance folks have their own
language, which could easily qualify as a foreign language to most of us. Not only do
they have their own words for things-they seem to have multiple words for the same
thing. Sometimes they talk about revenues. Sometimes they call it sales, or even net
sales, and in some places they refer to it as turnover. One minute they're talking about
revenues, then profits, then EBIT or EBITDA, then cash flow. It's almost like they're
trying to confuse the rest of us rather than tell us what's really going on in their
business.

Or maybe you're starting your own business. Congratulations! You have a great idea for
a product or service, you know they's significant market potential, but when you present
your idea to potential investors, all they want to know is how much revenue will you
generate and what the profits or cash flows are going to be. There are those terms
again, you can't escape them. They're everywhere. Well, if you would like to get a better
understanding of the language of business and finance, learn how to read the financial
statements so you can evaluate a company's profitability or solvency, or simply learn
how to forecast an income statement or balance sheet. Then, this is the right course for
you. My name is Peter Wilson. I'm on the faculty of Babson College in Wellesley,
Massachusetts and I've been making accounting and finance fun for my students for 20
years. I hope you'll join me for this adventure into the world of financial accounting,
where we'll take the mystery out of the numbers, eliminate your fear of the financial
statements, and have some fun along the way.

2. PETER WILSON-INTRODUCTION

Hi, my name is Peter Wilson, and I'll be your instructor for this course. A little
background on me. I'm on the faculty at Babson College where I teach graduate and
undergraduate courses in financial reporting and financial statement analysis. I've been
at Babson since 2010. Prior to that, I spent 19 years at Duke University. And before that
8 or 9 years at New York university. I love to teach and more specifically, I love the
challenge of trying to make finance and accounting-subjects that seems so mysterious
to many people, trying to make those subjects easy for people to appreciate and
understand. And what's really cool is figuring out how to use all the new technologies to
help people learn this material more easily, more quickly, more conveniently, and have
some fun while doing it.

I first started teaching in the online world back in 1995, and I've designed, developed
and delivered a variety of blended and fully online courses since then. Both in degree

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programs and in the corporate environment. What's interesting is that after spending all
that time trying to find new and different ways to deliver this kind of learning, I still feel
that we're just scratching the surface of what's possible. My current projects involve
gamification; scenario based learning and mobile applications as ways to make financial
learning more accessible and hopefully more powerful. When I'm not teaching, I like to
read, travel, cook. I'm a big sports fan. I grew up in northern New Jersey, so all New
York teams, which makes it a little painful living in the Boston area. But what I try to do
most of the time when I'm not working is play golf, and I've recently taken to collecting
golf balls from my students with their company or organization logo on them. I have
balls donated from all sorts of places Dell, what else do I have here? Goldman Sachs
and the U.S marine corps. And the reason I still have them is that I don't play with them.
I just display them in my office. Well, that's more than enough about me. I'm really
looking forward to working with you in this course, as together; we'll try to unlock some
of the mysteries of accounting and financial reporting.

2. WHY HAVE FINANCIAL STATEMENTS

Before we jump into all the gory details of financial accounting, let's talk about the
economic and regulatory environment in which financial reporting exists. Did you ever
wonder why do we even have financial statements in the first place? I mean, who uses
these things, what purpose do they serve, and who if anyone is in charge of the
process? I think if we can get answers to these questions, that will make the rest of
what we do in this course much easier to understand. Why do we have financial
statements? That's a question a lot of people ask when they first read a financial report,
especially when they see some of the strange line items that show up on an income
statement or balance sheet .Things like accumulated other comprehensive income or
unrealized gains on available for sale securities. Who comes up with these names?
Well, I like to think of financial statements as being similar to any kind of economic good
for which there is a supply and a demand. Demand mostly comes from people outside
the firm who don't have access to internal documents. First and foremost among these
are the investors and creditors, like we've seen with New England Boat Company.

There are also lots of other groups that want information, including customers,
suppliers, and the community in which the company is located and even various
government agencies like regulators and tax authorities. And speaking of government
agencies-one government agency that doesn't rely on the annual report is the taxing
authority. In the U.S, it's the Internal Revenue Service-they usually require their own
separate tax return that must be prepared according to the country's tax laws. The next
question to ask is how do we guarantee that the financial statements tell the truth and
are not filled with erroneous or misleading information? First, most jurisdictions have a
government agency responsible for making sure that the stock market or capital
markets in their country are fairly operating. In the U.S, we have the Securities and

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Exchange Commission. The SEC has the authority to administer fines and other
penalties when managers issue false or misleading financial statements.

Second, most countries also require that professional, independent accountants audit
the financial statements and express an opinion as to the accuracy of the financial
statements. This independent review of the financial statements is an important step in
providing assurance to investors, creditors, and others that the financial statements are
accurate and can be relied upon .To see what a sample audit opinion looks like, here
are some excerpts from a recent audit opinion on Tesla’s financial statements. The first
opinion of the auditor has to do with the financial statements. In our opinion, the
accompanying consolidated balance sheets and the related consolidated statements of
operations, of comprehensive loss, of stockholders equity, and of cash flows present
fairly in all material respects, the financial position of Tesla Motors and its subsidiaries,
etc etc in conformity with accounting principles generally accepted in the United States
of America.

The key phrases are first that the guarantee from the auditor is that the statements
present fairly the financial position of Tesla and second that the statements are
prepared in accordance with U.S accounting principles. The second opinion is about the
underlying process Tesla uses to prepare its financial reports. Also in our opinion, the
company maintained in all material respects, effective internal control over financial
reporting as of December 31st 2015, based on criteria established in internal control
integrated framework etc etc. So in the U.S, there are really two opinions provided by
the auditor: an opinion on whether the financial statements present fairly the financial
position of the company, and another opinion about the firm's internal control over its
financial reporting process. The rest of the auditor’s opinion provides information on the
responsibility of management-which is to prepare the financial statements and to
maintain a system of internal controls, and the responsibility of the auditor-which is to
express an opinion on the statements prepared by the managers of the firm. Finally,
there are several groups that you should know about, along with their acronyms, as they
are major participants in the reporting process. In the United States, the SEC or
Securities and Exchange Commission sits atop the food chain and has authority to
regulate both the accounting standards and the issuance of stock by public companies
that trade on any of the US stock exchanges. The SEC has delegated the duties of
setting accounting rules to the FASB- the Financial Accounting Standards Board. The
FASB is the group that issues accounting standards in the U.S which are referred to as
GAAP or Generally Accepted Accounting Principles. These principles serve as the basis
for financial reporting and the annual reports issued in the United States. Outside the
United States, each country or groups such as the European Union, has its own official
governmental agency, which is comparable to the SEC, that is responsible for the
financial reports issued by the firms in their country. Like the SEC, these agencies
require that companies use well accepted accounting standards to produce their
reports. In addition to the FASB, there is the International Accounting Standards Board,
which is an international group similar to the FASB-The IASB issues international
financial reporting standards known as IFRS. Can you believe all these initials? These

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international standards are similar, but not always exactly the same as U.S GAAP.
However, both sets of standards are universally accepted as legitimate basis for
preparing credible financial statements. And let's not forget our dear friends from the
taxing authorities.

Taxes and tax returns are prepared according to a completely different set of standards
usually set out in the tax laws of each country. It's important to understand that tax rules
are often quite different from financial reporting standards. Taxes are computed based
on a different set of rules, and are not to be confused with U.S GAAP or IFRS.

2. Week 1-NEW ENGLAND BOART COMPANY

Throughout this course ,we’ll be watching the progress of a fictional startup, New
England Boat Company, or NEBCO, as I like to refer to them .As you learn, NEBCO is a
new entrant in the boat building market and was founded by three former Babson
student entrepreneurs. Before we begin each week, you'll be able to sit in on the
meetings between the founders, Anna, Will and Bradley, as they struggle to apply what
they learned in school and balance the needs of their investors, customers, and
employees. As we meet them for the first time, they've secured funding and a location
for their boat yard and are preparing for the opening of their business.

Well, so I've been looking at some other locations for boatyards and I think that we need
to be at least in at least Florida and the west coast, and I think that we can look , need
to look at some international locations too. Somewhere in the France, Italy, Greece
area, maybe? All in good time, but right now I wanna make sure that our location in New
England is good to go for next month. I mean of course, but the investors are going to
give us at least 250,000-we need to go while the momentum is going, and if we get
international and national attention, I think we can become something really big. Look,
we've got a great location locked down in Connecticut. We've already fully staffed
location. We just need to get it up and running at a profit before we start thinking about
international expansion. I get that, but we can't just sit here in New England and run our
little boat yard. We have great momentum from the investors and all the sales interest,
and we need to act on it now. Bradley… Bradley! So I've been working on this great new
idea for a boat design and it uses this new resin. And it's 25% lighter and 40 to 50%
stronger than anything else on the market. What are you talking about? Are you even
listening to us? We're trying to get the Connecticut location up and running next month
and Anna’s already talking about going to Florida, California and Greece. I like Greece; I
did a semester abroad there in college.

You know, they have really nice sailboats over there. I wonder if I could use the same
resin and a forty foot windjammer. Forget it. Bradley. Let me let me ask you this. Are we
good to go for next month? I'm counting on it. Well, absolutely. Yeah, I just need to hire

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a few more people, but I know who they are. I just need to talk to him a little more. And
I've ordered the equipment and it should be here in a few days. Great .Anna, before we
start talking about conquering the world and international expansion, I need to know-can
we talk about the next steps for this month? We are in great shape as far as I'm
concerned. Last night I was thinking about when we started and you know, we did
everything we were taught in college, Entrepreneurial thought and action, the Babson
way and we did it without even thinking about it. What do you mean? The four steps,
remember we were going to build rowing skulls and then we realized that there were
already four or five great manufacturers, and the market was weak and flat. So we
looked into sailboats and motorboats. Bradley came up with those unbelievable
designs. You're welcome and thank me later. Well, so we crafted our opportunity
statement, which is still basically our mission statement. And then when we were
shopping Bradley’s designs around and that kind of became our industry analysis in
Step 3. And then we moved into Step 4, which was our feasibility Quick Screen and we
presented that to our investors in Boston and they became our principal investors. I
think they refer to that as subconscious assimilation. You know, so it's like ETA was like
DNA at Babson. It was infused, so it's no wonder we acted as we did. We were well
trained. So the money’s in, we have a location all signed for, we've hired people, we
have the machinery being shipped. What have we forgotten? There's one more thing,
actually, that we need to decide on pretty quickly. What do you mean? I thought we
were good to go. We are, but remember at our last meeting, Anna told us that one of the
conditions are investors are putting on us is they want regular reports and status
updates on our business. They wanna know how we're spending their money and that
we're making the kind of progress that Anna has been promising them. Ok, so what's
the big deal? They can come down to the boat yard once it's up and running, and see
where their money went. And, when the boats are coming off the line and the customers
are lined up they can see how successful we are. No, he's got a point. Our investors
want to see real financials and real progress. In fact, they wanna see our revenues,
expenses, capital investments and cash flow. And they wanna know our gross margin,
EBITA, ROA, ROE, acronym, acronym, blah blah blah. Oh yeah, I remember those
things from my undergrad days. Man, those accounting classes were painful. I tried to
forget most of that stuff. Yeah, no kidding. So what are we gonna do? I mean, clearly,
none of us is an account. Do you have anybody in mind?

3. WEEK 1-FINANCIAL ACCOUNTING OVERVIEW

Well, there they are again, those confusing accounting terms. You just can't get away
from them. And it doesn't really matter if you're a startup business or part of a larger
firm. At some point, you're gonna have to measure what you're doing and report that
information to people outside your company. If you think about it, the demand for this
kind of information come from all sorts of places. It can come from a banker who needs
the information before loaning you money or it may come from your investors who
wanna know if their investment is paying off. Actually, demand for financial information
could come from all sorts of folks, including your customers, suppliers, regulators, even
your neighbors in your community. Let's face it; there are all sorts of stakeholders who

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want to know something about your business. So let's start figuring out what all those
terms really mean, and take some of the mystery out of this whole process.

We'll start this week with a short video that lays out the different groups that get involved
with financial reporting. And of course, it's an alphabet soup of acronyms: SEC, FASB,
GAAP, IFRS. Seems like we have to convert everything into a set of initials, but no
worries I'll help you zero in on the important ones you really need to know about and
show you how they influence the financial reports. Next, I'll introduce a three primary
financial statements that will become near and dear to your hearts during this course.
The balance sheet, income statement, and the statement of cash flows. Unfortunately,
we have this problem of multiple names for some of these statements. For example, the
balance sheet is sometimes called statement of position, or the statement of financial
position. And the income statement is often called a statement of earnings, or a P & L;
profit and loss statement. What can I say? All I can do is apologize on behalf of the
profession for this confusion, but don't worry, it's not gonna slow us down. That kind of
thing will only be a minor distraction and we'll get past it in no time.

After this, we'll start to drill down a bit on each of the three statements-first, looking in
more detail at the balance sheet. This is the main financial statement from which all the
other statements flow so it's important to figure this one out first. Our analysis of the
balance sheet will then naturally lead to a discussion about how individual transactions
get recorded in the balance sheet. What I call keeping score .As a manager or
entrepreneur, your focus is usually in running your business and doing what you need to
do every day to try to make your company successful. It's the accountant’s job to
capture those transactions and record them in such a way that they can be nicely
summarized in your balance sheet. So we will spend some time on that and show you
how to analyze transactions and record them so they can be easily presented in one of
the financial statements. And don't worry; I'm not talking about debts and credits. We
are gonna use a much simpler process that makes use of the spreadsheet format for
recording transactions. And of course, sprinkled throughout will be an assortment of
other activities to keep you engaged. These will include calls to action, where I may ask
you to download information from a company's annual report, discussion activities and
short assessments that will give you the chance to apply, discuss, and test your
understanding and make sure you're getting what you need out of the course. So what
do you say, let's get started?

4. WEEK 1-INTRODUCTION TO FINANCIAL STATEMENTS

This video will provide a brief introduction to the three primary financial statements we'll
be covering in this course. While firms may produce a variety of reports and schedules,
these are the three most important statements that serve as the basis for
communicating the financial performance of a company. The balance sheet or
statement of financial position is a listing on a given date of the assets, liabilities and
stockholders’ equity accounts. The income statement and statement of cash flows

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provide information for a period of time that tells how well the firm has performed during
that specific period. Now let's look at each one more closely.

The balance sheet is the primary financial statement and that all other statements are
really just sub schedules or are derived from the balance sheet. The balance sheet is
defined by the accounting equation that states: assets of the firm must be equal to the
liabilities and stockholders’ equity. This makes sense when you define assets as
everything the firm owns, that will provide a future benefit. These assets must be equal
to the claims on those assets, where the claims come from the creditors and owners.
This is very similar to how you might create a personal balance sheet for yourself. First,
you would total up all your assets, things like cash, bank accounts, maybe a car or
house, or any investments you might have. Before you get to keep any of those assets,
you first have to pay off your debts, which are the claims by your creditors. Whatever is
left over represents your claim on the assets-what we call stockholders equity for a firm.
This lists some of the more common asset, liability and stockholders’ equity accounts.

Now, let's see how the income statement is derived from the balance sheet. This
happens in the stockholders’ equity section through the retained earnings account.
Retained earnings is the balance sheet account that captures any net income earned by
the firm during the year. In other words, when the firm performs and earns a profit, that
money belongs to the owners. And so their ownership interest increases via an increase
in retained earnings and stockholders’ equity. Note that when the firm decides to pay out
some of these earnings to stockholders as dividends, then this will reduce retained
earnings. To summarize, retained earnings is a cumulative account that increases
whenever the firm earns net income and is reduced whenever the firm pays dividends.
Also, if the firm has a bad year and encouraging that loss, this will reduce retained
earnings. Viewed in this way, net income is a subsidiary account to retained earnings
and the balance sheet. This graphic shows how the income statement is linked to
retained earnings, and helps to explain the change in retained earnings from one period
to the next.

While income statements will look slightly different from firm to firm, this generic income
statement lists some of the more common line items. You should take note that the
classifications are intended to help the user tell the difference between revenues and
expenses that are related to the firm's main operations, which is what leads to operating
income, or EBIT, and revenues and expenses that are not part of the firm's core
activities. Things like restructuring expenses, interest expense, and gains, or losses on
the sale of assets. After this, you usually get a subtotal for income before taxes and
income tax expense and then your bottom line net income. Of course different firms will
have different revenues and expenses and different gains or losses so you‘d expect to
see a variety of different line items than what you see here. The third statement is a
statement of cash flow, and it's designed to separately list the cash received and spent
on operating activities, investing activities, and financing activities. Operating activities
include any cash spent or received related to selling your product or service. Investing
activities include any cash spent or received related to things like buying or selling fixed

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assets or intangible assets, or even any investments you might have made in other
firms or businesses. And financing activities include any cash spent or received related
to financing your business, such as selling stock or borrowing and repaying loans.
Examples of cash flows for each of the three categories: operations, investing, and
financing are shown here. Just as the income statement helps explain the change in a
particular balance sheet account: retained earnings, the statement of cash flows is
designed to explain the changes in another important account: cash. Thus you can see
that there is a specific linkage among and between the three statements. And they each
provide a slightly different, but equally important perspective on the firm's financial
performance and condition. Next, you'll have an opportunity to test yourself on the form,
content and differences between the three primary financial statements.

5. THE BALANCE SHEET-A CLOSER LOOK

In this presentation we will take a deeper dive into the balance sheet and show some of
the differences between U.S GAAP and IFRS as they pertain to the balance sheet. The
technical definition of assets is resources owned by the firm that will provide a future
benefit. In other words, they're not used up but still hold some future value to the firm.
For example, accounts receivable are expected to be collected in the future. Inventories
will be sold for cash, and machinery and buildings will be used to house the business
and manufacture the products that will be sold. They all have in common this idea of a
future benefit to be received by the firm.

A couple of other things to note about assets: We tend to use a mix of valuations in
recording assets. Many assets like inventories, fixed assets, and intangible assets are
recorded at their historical cost, what the firm paid for them, while other assets like
investments in marketable securities and other financial assets, are recorded at their
current market value. Not much we can do about this, you just need to realize that there
are a variety of valuation basis used for assets. In addition, assets are grouped based
on when they'll be used or converted into cash. Those assets to be used within the year
are classified as current, and those to be used beyond one year are classified as non-
current. Liabilities are defined as obligations of the firm that will be paid either in cash or
services and are a result of a past transaction. Like assets liabilities are also grouped as
either current or non-current. Current liabilities will be paid or settled within a year. Non-
current will be settled beyond one year. Stockholders’ equity is really a collection of
accounts that record different types of transactions with the owners of the firm. It can
also be called shareholders’ equity or owners’ equity.

The main accounts are common stock and additional paid-in capital. These two
accounts together represent the amount of cash the company received when it initially
issued its stock to the public, such as in initial public offering or IPO. This is not the
current market value of the stock, but rather the amount received in the past when the
stock was first issued. Retained earnings we've already discussed. It represents the
cumulative net income or net loss of a firm less any dividends paid out to shareholders.
Treasury stock represents the total cost to the firm of buying back its own stock from

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shareholders when the firm does a stock buyback or a stock repurchase. Since this type
of transaction decreases the number of stockholders in the firm, it is shown as a
negative amount or subtraction from stockholders’ equity. And accumulated other
comprehensive income: this is really a technical account, the details of which are
beyond the scope of this course.

There are slight format differences between US GAAP and IFRS balance sheets.US
GAAP balance sheets are based on the equation assets, equal liabilities, plus
stockholders equity, while IFRS often rearrange as that equation as assets minus
liabilities equals stockholders equity. And while u s gap was assets and liabilities in
order of decreasing liquidity with the most liquid assets listed first, IFRS balance sheets
do just the opposite, starting with the least liquid assets and liabilities, for example,
here's a sample of a US GAAP balance sheet for kroger, the grocery store chain. You
can see how totally assets equal the sum of liabilities and stockholders equity, and how
the listing of assets and liability is in order of decreasing liquidity.
And here is the balance sheet for jay sansbury, a grocery store based in the uk that
reports under IFRS here. The overall format is to list assets first in increasing order of
liquidity, then to subtract liabilities from this amount to arrive at stockholders. Equity is
really just a formatting or presentation difference. More than anything else. It can be
interesting to note the different balance sheet profiles that occur when firms are in
different industries or employ different business models are operating strategies before
moving to the next slides. Think about how the balance sheets might be different for a
product or service firm, or a firm that owns its own manufacturing facility versus one that
out sources production to an unaffiliated third party or a firm that prefers to grow
internally versus another firm that grows by purchasing other businesses. The following
slides provide some examples. First here are the balance sheets of yahoo and dow
chemical presented in percentage form to companies in different industries with different
business models and strategy. Can you identify which karma data pertains to dow
chemical in which one pertains to yahoo? Post your best guess on the reasons for your
decision to the discussion board? Does everyone agree with you? Same exercise. Here
we have the balance sheets for city bank and nike, again decide which is which
imposed your selection and reasoning to the discussion board and one more pair apple
and walmart again, decide which is which, and post your selection and reasoning to the
discussion board. Hopefully, you all have a better idea for the balance sheet. Now next,
you'll be able to demonstrate your understanding of the balance sheet with some
questions for you to talk about on the course discussion board.

6.KEEP SCORE FROM TRANSACTIONS TO FINANCIAL STATEMENTS

A whenever I get calls from former students with a reporting question. It invariably
revolves around trying to figure out how a particular deal or transaction will be shown in
the financial statements. Will it increase or decrease net income? Does it all get
recognized currently or some future period? The tool we use to answer these questions
is transaction analysis, which is the required first step firms take when making a journal
entry to record a transaction. This is arguably the most important tool for you to master

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when learning about financial reporting. And it's our focus for this segment. Now, don't
worry, no debts or credits here. Instead, we will use the accounting or balance sheet
equation as the basis for analyzing transaction. Most people find this to be a much more
intuitive approach to journal entries. Remember the accounting equation in which the
balance she is prepared assets equal liabilities plus stockholders equity? I hope so.
Since we've talked about it in the last two segments, this is a very useful equation,
because we can use it as a framework to analyze and record all the financial
transactions entered into by a company. Before I show you how we do that, let's
separate out the income statement accounts that are embedded in the retained earning
section of stockholders equity. To do that, recall that stockholders equity is generated in
two ways from investments made by owners in exchange for stock, which we capture in
the common stock accounts, and from the earnings or net income that are retained by
the firm. What we call retained earnings. Retained earnings is really made up of the
cumulative net income the firm has earned over its lifetime, less any dividends that is
paid out to shareholders. Thus the name retained earnings. And finally, we can break
net income down into its main elements, revenues and expenses. When the balance
sheet is decomposed in this manner, IT's easy to see why, say that income statement is
really just a sub schedule of the balance sheet. IT helps to provide more detail on a key
element of stockholders equITy and retained earnings,
net income. The expanded formulation of the balance sheet equation, then can serve as
the basis for recording the many buying and selling transactions the firm engages in
during the year. The main rules that after making a journal entry, the equation must be
imbalance. In other words, if a transaction causes an increase to an asset account, this
must be balanced out by a decrease to another asset account, or an increase to a
liability or stockholders equity account. Otherwise, the equation will not be imbalance.
Thus, a journal entry will always require at least two entries to keep the balance sheet
equation and balance what is often referred to as double entry bookkeeping. To make
this format a little easier to use, I like the template you see here, which makes use of a
spreadsheet format, which can easily be created in whatever spreadsheet software you
prefer. Here, you see, we have the headings for the assets, liabilities, and stockholders
equity sections. Within each section. We can add columns for individual accounts, or
just leave the columns as general headings. This is totally up to you and how much
detail you want to record. Since so many transactions involve cash, i've created a
separate column for increases and decreases to cash, and will record any other asset in
the other asset column. You'll also note that i've broken out separate columns for
revenues and expenses with a total calculated for net income. This just makes it easier
to see the changes to net income as they occur. Whenever you record on a mountain,
the revenue or expense column, net income will increase or decrease, and soul retained
earnings. Thus the arrow showing the connection between net income and retained
earnings. Let's how all this works with a few transactions that don't involve any
revenues or expenses. We'll look at those next week. The first transaction will look at is
the purchase of fixed assets. Soon, the firm buys ten thousand dollars of equipment for
cash,
although this is a fairly simple and straightforward transaction. The first step in
determining what journal entry to make is to figure out exactly what the firm is giving up

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and what it's receiving in the transaction. This will help you to identify which accounts to
increase or decrease. And by what amount here, the firm is giving up ten thousand
dollars a cash. So cash decreases, and it's receiving ten thousand dollars of equipment.
So the other asset column is increased by ten thousand dollars. Note the summary
effect of the journal entry, one asset, decreased cash, and another asset equipment
increased by the same amount. Thus the balance sheet equation stays on balance in
the journal entry is complete. Next, the firm borrows fifty thousand dollars cash. They
received fifty thousand dollars in cash, and they give up a promise to repay the fifty
thousand dollars. According to the terms of the borrowing, which are not specified here,
this promise to repay fits our definition of a liability, an obligation of the firm requiring
payment in goods or services. That is the result of a past transaction. Thus the journal
entry will consist of an increasing cash, a fifty thousand dollars, that is balanced by an
increase in a liability account, no, payable a fifty thousand dollars. The balance sheet
equation stays on balance, and the journal entry is complete. Let's look at a stock
transaction. Assume the firm issues, or cells, as we say, ten thousand shares at a price
of five dollars per share. What has the firm received and what have they given up in
exchange? Clearly, they receive fifty thousand dollars for the stock. In return, they've
given up ownership rights in the firm, which at the time of the transaction are worth fifty
thousand dollars. So the journal entry to record this will increase cash fifty thousand and
increase stockholders equity via common stock by fifty thousand as well. Note that the
fifty thousand dollar increase to common stock and stockholders equity represents the
market value of the stock on the date.
The firm issues the stock to the public. While the market value of that stock will then
change from day to day. The firm will not make any journal entry to recognize that
change in market value. Instead, the common stock account will always remain at the
amount originally invested, in this case, fifty thousand dollars. Now assume the firm
decides it doesn't need all to cash for current operating needs. So it invest some of its
extra cash in the stock market fund spends fifteen hundred dollars and acquire shares
in a stock fund cash of fifteen hundred decreases. And in return, a short term
investment account and asset is increased. This entry is similar to our first entry in the
firm purchased equipment. Buying any asset for cash will result in a decrease to cash
and then increase to another asset account.
7. WEEK 1-WRAP UP

Congratulations, you made it through week one. And i'll spend a couple minutes just
wrapping up some of the key take ways for the week. One of the more interesting things
we did this week was look at the balance sheets to try to figure out which company was
which. Uh, the dow yahoo comparison? Most people honed in on the fact that they
expected down to have more inventories and pp any yahoo doesn't even have
inventory. So that pretty easily identified a company a as dow. You should also note that
dow carries a lot more debt. Their cash flows and earnings are probably a little more
predictable and stable, allowing them to take on a little more financial risk. Yahoo! In a
little riskier business is not gonna carry as much debt for city bank in nike. This was

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pretty easy. I think the uh, again, nike has inventories and city bank has a lot of short
term uh, assets and current liabilities. All their financial assets and liabilities are tend to
be current in nature. Uh, they also have a lot more debt in their capital structure, uh,
given the fact that there are financial institution. So that's pretty typical of a bank. So
company a is city bank and b is nike. And then apple and walmart maybe not quite so
clear. But most people honed in on thinking that walmart would have much higher
inventories and p p and e our property, plant and equipment, as we say, which is
company a that is walmart. The other thing you notice about apple is they have very
high short term and long term investments, which is the result of all the cash, uh, they
have on their balance sheet over a hundred billion dollars of cash, which they invest in
the short term, and long term investments until they find other uses uh, in their
business. So the key take ways I want you to have for the course are one

how a firm strategy or business model can be revealed in the financial statements and
in the dance eat in this case. And we saw that with the three pair wise comparisons, we
just went through two, that the balance sheet equation is a very powerful tool. We can
use that to record all the firm's transactions and will be continuing to do that in week two
and three, you really need all three statements to tell the complete story about a firm's
performance. You can't just rely on the income statement. You need the balance sheet
in the statement. Cash flow to get really a complete picture of the firm's financial
performance.

8.WEEK 1-KNOWLEDGE CHECK REVIEW

I thought it would be a good idea to walk you through the answers to the second
knowledge check in week one. Most of those were pretty straightforward, I think once
you saw the answers to, but there a couple of them that, uh, like people thought might
have been a little tricky. And so I want to go through the answers to all of them.
Question one, you sell stock thirty thousand shares at twelve dollars a share, so you're
gonna receive three hundred and sixty thousand dollars of cash. So cash goes up. And
then we have to provide evidence that we now have more shareholders in the firm. So
the shareholders section of the balance sheet has to increase. And we put this in an
account called common stock to show that we have issued common stock to our
shareholders in exchange for three hundred and sixty thousand dollars a cash in
question two manufacturing equipment is purchased for ninety five thousand dollars in
cash. So cash goes down and another asset equipment goes up. This is what we call a
capital transaction, or were capital i's ing the cost of the equipment. When you capitalize
something, you record it as an asset. So the correct answer here is d number three was
a lITtle tricky, because here we have a special installation. And testing is required in
order to get the equipment ready for use. And a lot of people would probably inITially
think, oh, you should expense this. IT's an expense. You're paying some workers or
somebody to come by and set up the equipment. Now, you know cash goes down

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fifteen hundred dollars. But what the accounting rules say is if, uh, these are costs that
are necessary are required to get the asset ready for use, you should capitalize those
costs along with the purchase price of the equipment. So this fifteen hundred dollars
would be treated just like part of the purchase price would capitalize it or add it to the
equipment account on the balance sheet. So this would increase the recorded cost,
or as we say, the book value of the equipment. And then it would be mean there's a
larger amount to depreciate going forward. So this would be so the best way to handle
this would be to capitalize this fifteen hundred dollars added to the cost of the
equipment on the balance sheet. And question for you obtain a patent patents purchase
for twenty five thousand dollars. Only you don't pay cash. You sign a note. You issue a
note saying i'll promise to pay you uh, in a year at the end of the year. So in this case,
an acid still goes up patent, uh, twenty five thousand dollars instead of cash going
down, because we're not paying cash right now. We now have a liability that we're
gonna have to pay off. So the liabilities go up. We call it note payable. Uh, so the correct
answer there is a number five, you're buying raw materials inventory. So this is very
similar to bind equipment or any other kind of asset. You're paying cash. So cash goes
down forty thousand dollars. And another asset, raw materials inventory goes up forty
thousand dollars. So you're really just exchanging one asset for another. Now, if you
discover some of that materials, some of those materials are defective, and you want to
return them. That's fine. So you send him back the different ways you can do that here.
We'll keep it simple. So we call up the suppliers, so we're going to send them back. We
can't use them at all. You know, sometimes they'll give you a price discount or
something like that. Here. We don't even want to, we want our money back. So we send
him to the supplier. They send us our money back. So we basically just reversing out
the previous entry to the tune of eighty eight hundred dollars. So we're going to add
eight hundred to cash and subtract eight hundred to inventory to uh, provide evidence of
the return. And that's answer a
in seven, we open up a line of credit with the bank for a hundred thousand dollars. Now,
opening up the line of credit doesn't require a journal entry. IT's only when we start
taken some of the cash on the line of credit. So when we borrow forty thousand dollars
that we make an entry for. So cash increases because we're borrowing forty thousand
and we have a loan, the liability alone payable of forty thousand dollars. Now we're
gonna have to pay interest on IT. I understand that, but we don't recognize any interest
yet. You recognize interest expense as time passes. IT's only while you use the money
while you have the money and you're doing something with it. As time passes, that you
actually get charged interest expense. We often refer to that as the time value of money
or money has a time value to it. In other words, uh, you incur the expense of using the
money over time. So until time passes, we're not gonna recognize it. So technically,
we'd wait till january twenty second on january twenty third to recognize some of the
interest expense. As a practical matter, companies will just do that periodically, like once
a month, or every, probably once a month or every quarter, uh, whenever they want to
update their accounts, that's when they would recognize the interest expense. A
question? IT's an interesting one, because here we sign a lease for a retail location. And
the lease agreement requires lease payments of thirty five hundred dollars a month,
where in january the least doesn't begin till february. So we haven't done anything. We

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haven't made any down payments or anything. We agree that on february first will write
a check and will take occupancy of the, uh, shop of the store of the building. So at this
point, all we done a sign, an agreement sign, a lease agreement. We have given up any
cache. We haven't received any cash, nothing else has traded hands.
So we call that an executor rick on track, meaning that neither side has performed their
side to the contract. And in the accounting world, we make no entry for that uh,
transactions. So obviously, you have legal documents, and you'll know that you've
entered into agreement. We just don't make a journal entry into the accounts until
something else has traded hands. All right, if we had gone ahead and made a thirty five
hundred dollar payment, then we would record that we would reduce cash and show it
to some sort of prepaid rent as an asset account. But until we do that, uh, no entry is
required. Now, compare that to number nine, where we actually do pay something. All
right, so we're doing the same sort of thing. We're buying a two year insurance policy in
advance. IT's january. The insurance policy is gonna begin until february first, but we
actually wrITe a check. So the fact that something addITional has traded hands, IT's not
just an exchange of promises to do something, but we've actually written a check and
send it along. We've got a record that. So cash goes down ten thousand, and we record
an increase in an asset account called prepaid insurance. So that's answer be. And then
each month for the next two years, we would take out what? One twenty fourth of the
prepaid insurance and show it as insurance expense on the income statement. These
executor rick on tracts are always, I think, a little unusual people knew to the discipline.
And here's just another example of it. And probably, you know, we really think about this
a lot with our favorite sports teams or whatever our football team or basketball team
signs a star
uh, player. Uh, there's always, you know, make a big deal about the contract. They get
twenty million dollars, fifty million dollars, whatever it is. And just signing the contract,
signing somebody to that. There's no journal entry in the uh, books. IT's only when we
actually pay their salaries. So filling several key positions on the management team,
hiring them for long term contracts, agreeing to pay them fabulous amounts of money.
None of that gets recorded. We wait until they work for us, and then we accrue salaries
expense in we write him a check. We show that decrease in cash. So number ten,
correct answers a no entry required just for hiring somebody in agreeing to pay him a
certain salary.

9.WEEK 2-NEW ENGLAND BOAT COMPANY

Ooh, even though new england boat company is not a public company listed on a stock
exchange, it does have investors and creditors. And as soon as you have outsiders
involved with your firm, you'll need to be able to prepare financial statements and
financial reports that are in a format. Your investors are used to seeing. This is when
most entrepreneurs get introduced to accounting principles and accrual accounting. So
now let's check back in with honor will and bradley as they near the end of their first
year of operations. Suddenly those fuzzy accounting concepts become pretty important
as they realise they need to report out to their investors on their progress for the first

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year. Hey, guys, thanks for making it for this meeting. I know we've all been running flat
out since we started, but I think it's really important we stay in touch. We just stay on
target for what we're doing for this business. I want to be sure we have the company
going where we want it to. And I have a feeling that we've been so busy running around
putting out fires that we kind of lost sight of the big picture. What are these big picture
goals? We're forgetting about. Come on. You know what i'm talking about? I didn't get
into this. So he could be a nice little quaint boat company in new england. What do we
study at babson? Disruption and more disruption? I think that's what we have here,
where with bradlees been able to do with using new technology and the new boat
designs, we're building the best bow to the market at a fraction of the cost. And as soon
as the world figures out what we're doing, I think it's gonna be very, very big. We need
to be ready to take off. I get it. I'm still with you on the big picture idea. I just want to
make sure that our little operation here in connecticut is up and running and and
profitable. And we want to be confident that we can recreate it wherever we go. I agree,
but we can't just sit still and run one boat company up here in new england. We need to
keep pushing forward, especially while we have all the good momentum from the
investors and this sales interest receive to have.
Oh, i'm with anna, let's conquer the world. Great. So let's talk about how we're really
doing. Ok, so we have a meeting coming up in a few months with our investors, and
they're going to want to a review of how we do of how we've done this year. I want to
make sure we're prepared to make a good presentation. Bradley has the production
line. Well, the process is pretty much perfect. I knew it would be just like I designed it is
that it? Because i'm not sure it is going perfectly well. So the process is pretty much
perfect. And the people I have there, good. But they're not perfect. IT's just, well, this
month is going better than last month, and they're learning the process. IT's just taking
longer than I thought. So we're we're not where I think we could be. Do you feel good
about it? How long until we're building boats as fast as we can? Well, so I do feel good
about it. And we should be at full speed by the end of the year when we have our
meeting. All right, so how are things going on the sales front? Oh, IT's been great so far.
We probably have what bradley, ten, twelve both working on right now. And I have more
orders than a dozen or so, and they're strong orders, which means I have about a down
payment on a third of those. And on top of that, i've been having trouble keeping up with
all the sales leads we've had. Ok, why is that? Because i've been helping our finance
guys track down each and every one of our customers after we after we get the boats.
I'm a little worried about our cash flow. I keep having to draw in the last fifty thousand of
our investor money just to make payroll and and and pay or vendors, well we better be
able to make those payments. Are you telling me we're running out of cash? I thought
with all the sales we've had, we be cash flow positive by now. This is supposed to be my
big punch line to the investors that we wouldn't have to hit him up for any more money.
Right now,
the entrepreneurs dilemma what? Well, you know, they told us about this in school. IT's
the entrepreneurs dilemma. Things are going well, people keep calling, buying boats,
and then the business runs out of cash. Well, I can tell you one reason we're having a
hard time, and that's because some of the boats we've delivered aren't even finished.
Some of the things aren't done in the rigging is not complete, and and they're

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withholding payment. So I know, I know and this goes back to some of the problems i've
been having with my people. You know, they're three or four boats have gone out that
aren't completely a hundred percent done, but we're dealing with it. I hope you're
dealing with it. We should have had this meeting a lot earlier. I mean, come on, guys.
We can't be sending out unfinished boats. This is our brand, our reputation we're talking
about. And it's not only that if we send out bad product, then we don't get paid. And we
have to hit up our investors for more money. And they lose confidence in us. And this is
a road we can't go down, agreed, agreed. Yeah, bradley, how about you? And I get
together right after this meeting. Get better coordinated on what we're telling our
customers and when their boats are ready and how we're going to get paid. This is just
too important. If you think you can fix the problems on your end. I think I can work with
our accountants to get every possible number into the sales figure. Please just make
this happen. And while we're all the subject exactly what is going into our sales figure, I
kind of want to have an idea so I can start planning what we're gonna say to the
investors. Like I said before, sales should be pretty good between the boats we've built
and the ones we're working on, we should have about thirty to thirty five units to show.
Ok, good, great. I like that. Wait a second. I don't think you can record all of those as
sales. What do you mean? Also, I did pay a little bit of attention in accounting. And
there's something about uh, what you can record is a sale on what you can't.
Uh, IT's something to do wITh the earnings process, so you can't actually record a sale
unless the boats been complete, uh, delivered and accepted by the customer. You guys.
This meeting is going to make me physically ill. First, you tell me we're running out of
cash. Then you tell me we're putting out unfinished product. And now you're both telling
me that we don't know what we can counter sales, please figure this out. We need to
know what the accountants will and won't count as a sale. Maybe we can shift around
some production so we can get more into that number. Yeah, okay, perfect. And we're
not shipping out any more unfinished boats.

10. WEEK 2-FINANCIAL ACCOUNTING OVERVIEW

Ooh, one of the things you learn early in this business, a financial accounting is that
what you initially thought was a simple and straightforward process can get complicated
pretty quickly. Buying and selling nothing difficult or confusing there. Right? You buy
equipment, you give up cash, you get some equipment. Nothing hard about that. Same
with a sail. Customer comes in, gives you some cash or a credit card, and you give
them the product, a simple exchange, a new record, the sale based on the price of the
product. Right? Well, sometimes that's the case, but not always, as we just saw with the
folks at new england boat company. Not all sales take place at a single point in time.
Maybe that's true for a retail operation like a department store. But for many business to
business transactions, the sales process takes a lot longer. First, the seller has to
receive in order, maybe online or by phone, then it may take several days or even
weeks to complete and ship the order. That's certainly the case for a boat company. And
even then, shipping can take some tiling before the product finally makes it to the
customer. In these cases, we have to be very careful about what units we consider to be
sold at any point in time, and therefore appropriate to include as sales in our income

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statement. The income statement is designed to cover a very specific period of time a
month, three months a year and can only include sales and expenses that took place
during that time period. Do we report all the orders received during the period of sales?
Even if production doesn't take place during that period? Or should we include only
those units that we've started to work on during the period? Or maybe just include the
units we've completed in ship during the period or completed, shipped, and delivered?
All of a sudden, there are lots of alternatives, lots of choices. And this is a pretty
common scenario. As you think more about this, you also realize how significant the
impact can be on your income statement. And consequently, on how successful you'll
look to your investors,
you can arrive at a big number for sales by including all the orders you've received,
regardless of whether or not you fill those orders. On the other hand, you can end up
with a much lower number for sales by only including those units that actually have
been delivered to your customers. And if i'm the manager of the business, i'm naturally
inclined to want to make the business look as strong as possible and to try to report the
biggest number for sales in that income that I can. Of course, my investors and creditors
want the income statement numbers to be as accurate and reliable as possible. They
don't want their managers always reporting overly optimistic estimates of sales or net
income. They want a clear line of sight into what's really happening inside the company.
This is where the accounting standards, like u s gas pour, I f r s come into play to
provide guidance to managers when they have to exercise this kind of judgment. This
week, we're gonna look at several of the most common and important transactions that
often require judgment on the part of managers and show how the accounting
standards can help us make reporting decisions that are both fair of the business and
useful to our investors and creditors. Topics will cover include the basics of revenue
recognition, inventory and costs of good sole expense, and capitalization versus
expensive understanding. These concepts will give you the foundation you'll need to
start to analyze financial statements and evaluate a firm's financial health topics will
address later in the course.

11.WEEK 2-REVENUE RECOGNITION

A let's start this week with revenue recognition. This is the most important area to get
right for both firms and their investors. And as you might suspect, accounts think about
revenue a little differently than how most of us think about it in our everyday lives. But
that's okay, because that's why you're here to learn how accountants think might be a
little scary, but good to know. Let's start with a simple example. Assume your firm gets in
order for five units at two hundred dollars apiece in their first quarter. Q one. It takes you
a while to finish production, and you end up shipping and delivering the goods. And q
two, since you sell on credit, you send an invoice to your customer and they pay you in
quarter three. Question is, in which quarter should you recognize revenue? Q one, q
two, or q three? Under the cash basis. You would wait until q three, since that's when
you get the cash. This is how most of us operate in our daily lives. You don't really feel
like you've earned your paycheck until you get it in cash. Am I right? But the accounts
look at it a little differently because they wanna show revenue in the period in which the

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firm did all the work to complete the sale, which is q two. In this case, getting the check
or cash payment is important, obviously, but doesn't really require any significant effort
by the seller. So it is not viewed as a critical factor in determining when the revenue is
earned. That's really the basis for accrual accounting recognize revenue in the period in
which it is earned when the earnings process is complete, cash collection can happen
at a later date. Let's look at a little more elaborate example. Lets assume that on july
fifteenth, conquered farms, which is a dairy farm, receives an order for ten thousand
gallons of milk. Price is two dollars a gallon. The milk won't be delivered until sometime
in august. So what do you do?
Even though this is clearly an important order for conquered farms? The accounts don't
do anything. At this point, no entry is made, because nothing has been exchanged other
than promises. Something more tangible must be exchanged, like cash or the product
before the accounts will make a formal journal. Entry conquered farms can still let their
investors know that they've received such an order. And any other backlog of orders that
are not yet filled. IT's just that no formal entry is made at this point. By august tenth, the
milk is ready, bottled up and delivered to the grocery store. As is customary in many
businesses, conquer delivers an invoice along with the milk and request payment within
a few days or weeks. At this point, since payment can be reasonably expected to
happen, the earnings process is complete, and conquer can go ahead and recognize
revenue with the journal entry. And the journal entry looks like this. First record twenty
thousand dollars as revenue. This will cause an increase in net income, which in turn
increases retained earnings. However, our balance sheet equation is not in balance yet.
While we would normally want to increase cash by twenty thousand dollars, we can't
because we don't have the cash yet. But since the customer is now obligated to pay us,
we can record this obligation as an account receivable, which just represents money
owed to us by our customers. And this puts our balance sheet and balance assets,
equal liabilities plus stockholders equity. Then a few days later, on august twentieth,
when the customer pays their bill concord records on increasing cash and a decrease in
accounts receivable. Since the obligation from the customer has now been paid. So you
should know here that the revenue was recognized when the milk was delivered, not
when cash was received. This is the heart of accrual basis, accounting when cash is
eventually received. IT's merely an exchange of one asset cache for another asset
accounts receivable.
Well, since this is so much fun, let's look at another example. Let's look at the situation
where your customer pays you up front before you've delivered your product or service.
Usually this is in the form of an advanced payment the customer makes to ensure good
service or guarantee delivery. Here, we assume a new customer submits an order for
ten thousand dollars of milk that makes it twenty five hundred dollar down payment.
Notice the difference between this and the previous example where the customer
submitted in order with no advanced pain. In that case, we didn't make any entry. But
here, since something more tangible has been exchanged, we can account for that part
of the transaction conquered receive twenty five hundred dollars in cash, so we must
recorded increasing cash of that amount. But we can't recognize this as revenue yet,
because conquered has not completed the earnings process by delivering the milk. So
what do they do? Can't leave it like this. We're not in balance on no account worth. Their

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salt can go home for the day until all the accounts are in balance. IT's just just not done.
The solution is to understand that by receiving the twenty five hundred dollar down
payment conquered now has an obligation to complete the sale to the customer. This
obligation is a liability, and we call it unearned revenue, or sometimes deferred revenue.
Then when conquered, delivers the milk and completes the earnings process, they can
recognize the full ten thousand dollars a revenue, which, as before we see increases
net income and retained earnings. Since the sale has been completed, conquered no
longer has a twenty five hundred dollar liability. So this can be decreased and the
customer still owes conquered seventy five hundred dollars for the rest of the sales
price, which we record as an increase to accounts receivable. And finally, when the
customer pays their bill, we increase cash and decrease accounts receivable for the
seventy five hundred dollars.
Key things to remember. Under the accrual basis, revenue is recognized when the
earnings process is complete, usually when the product or service has been delivered
and not based on when the cash is received. This means that revenues do not always
equal cash flow. And we will see the same thing with expenses, which should lead you
to realize that if revenues don't equal cash received and expenses don't equal cash
paid, well, the net income is not going to match cash flow, which is what ultimately leads
to the need for the third statement, the statement of cash flows, which we'll look at a bit
later.
12. INVENTORY COST FLOW ASSUMPTIONS

A when you look at many income statements, the line item immediately below revenue
is often something called cost of good salt, or cost of revenues, or sometimes cost of
sales. I know multiple names again for the same thing. Very annoying, but it comes with
the territory. In this video, we will examine cost of good salt, how can be computed and
how it relates to our accounting for inventory. This is probably best explained within the
context of a simple example. Assume we have a company that has no inventories, start
the year, and purchases five units of inventory during the year. There's rampant
inflation, and the cost of the inventory goes up by one dollar at each purchase. So you
end up with five units of inventory, each with a different cost, a one dollar unit, a two
dollar unit, three or four, and a five dollar. You. At the end of the year, you sell two units
for ten dollars each. Now, you know your sales revenue will be twenty dollars, but which
should be the cost of goods sold. You know, you sold two units, but which two units?
The cheap ones, the one dollar and two dollar units, or the expensive for dollar and five
dollar units. It obviously makes a big difference in how much net income you'll show for
the year. I suppose if every company had state of the art inventory systems with bar
coding and electric scanning, keeping track of which particular units are sold at each
time, this might not be such a big deal. But the accounting systems have to work for all
sorts of businesses, for highly automated ones, to manual systems. So to make things a
little easier on the firm, the accounting rules allow firms to adopt an assumption about
which units gets old, what we call a cost flow assumption. This cost flow assumption

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does not have to match the physical flow of goods. Firms can still manage the physical
flow of goods however they want.

But when it comes to figuring out which inventory units have been sold so they can
compute cost of goods sold in the remaining ending inventory, firms can pick one of four
costs, low assumptions, with a requirement that they stick with the same assumption
year after year and apply it on a consistent basis. The for cost assumptions are specific
identification, which is what you might use if you had one of those state of the art, high
tech inventory systems, average cost, first in first out and last in first out. Since specific
identification is pretty self evident. I won't discuss that method, but we'll illustrate the
other three methods using our simple example. First, a look at average cost in this
method, an average cost for the years calculated by taking the total cost of all goods in
beginning inventory and purchase during the year, in this case, fifteen dollars, and
dividing it by the total number of units available. In this case, five, the average cost of
three dollars is then applied to both the unit sold giving us a cost of good sold of six
dollars and apply to the units remaining in inventory, three units at three dollars each, or
nine dollars first in first out or fifo assumes the oldest units are sold first, leaving the
newer more recent purchases in ending inventory. In our example cost, a good soul
would be assigned the one dollar and two dollar units for a total cost of good sold of
three dollars, leaving inventory with a three dollar for dollar and five dollar units for an
inventory valuation of twelve dollars. Last in first out or lifo makes the opposite
assumption from fifo under life o the most recent purchases are assigned to cost a good
sold. Here are the five dollar in the four dollar units for a total cost, a good sort of nine
dollars leaving inventory with the older purchases here, the three dollar two dollars one
dollar units
for an inventory value of six dollars. You can see the difference the cost flow
assumptions can make on your gross profit in that income, as well as on the inventory
valuation that shows up on your income state. Thus, firms are required to disclose what
cost flow assumption they're using. At the same time, IT's important for investors in
analyst to understand this as well, so they can properly interpret the amounts they see
for cost of good sold gross profIT and inventories. I should also point out that life oh, is
allowed under u s gap, but not under I f r s life was developed years ago as a tax
reporting method that would allow firms experiencing consistent inflation to show a
lower gross profit. As you see here in our example, and thereby minimize their tax
liability. However, this is just a temporary deferment of the tax, because, as you see
here, when those low cost units in inventory eventually do get sold, there will be a much
higher profit realized and higher taxes to be paid as well. Now that we understand the
cost flow assumptions. Let's look at the journal entries for inventories and cost of good
sold. First. The purchase of the inventory is pretty straightforward. Here, inventories
purchased for cash, so cash decreases by fifteen dollars. An inventory increases by
fifteen dollars. In the accountants lingo, we are capitalizing the fifteen dollar cost as an
asset inventory until the units are sold, at which point we will expense the cost of the
units sold. According to the cost flow assumption we've adopted when you sell your
product, IT's important to realize that we record the sale and cost of good sold as two
separate entries. We do this because we want to show the selling price on the income

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statement as revenue separately from the cost of good sold and not just show a single
net amount of the difference between the two,
the sales entry we've now seen before. We record the twenty dollars selling prices
revenue with the associated increased in net income and retained earnings. And if we
assume this to be a credit sale, there will be an increase to accounts receivable, the
cost of goods sold, entry accounts for the reduction of inventory and the recognition of
the cost of goods sold expense. Under the average cost assumptions, the units sold are
cost it at six dollars. So inventory is reduced by six dollars, and and expense of six
dollars is recorded. This six dollar expense causes a decrease in that income and a
decrease and retained earnings when the customer pays their bill, cash increases by
twenty dollars, and accounts receivable decreases by twenty dollars. Some final
thoughts. Most firms use the average cost or fifo methods, with life only used in the u s
and primarily by firms that have experienced significant inflation and their inventory. At
some point in their history, firms cannot switch costs, low assumptions from one year to
the next. They need to keep applying the same methods from year to year. IT's probably
occurred to some of you that if your firm doesn't sell a product, but rather sells the
service, it won't have inventories, and therefore no cost a good soul. This is true, but
many service firms will still compute a cost of services, which can include things like the
labor cost of those employees that deliver services to their customers, all of which
points to the importance of reading the footnotes, the financial statements, which is
where the firm will explain the methods and assumptions it uses when accounting for
the sale of its products and services.

WEEK 2-DEPRECIATION AND FIXED ASSETS

A in this section, we will look at another example of costs that are initially capitalized as
assets, and then expense when the assets are used by the firm. Fixed assets comprise
things like buildings, machinery, and equipment that firms buy and use over many
years. Depreciation is the process by which the cost of these long term assets is
expense to the income statement. When fixed assets are purchased, they're often
material associated costs. In addition to the purchase price that must be paid in order to
get the assets delivered installed and ready for use in the business. Accounting rules
require that all costs that are necessary to purchase and get the asset ready for use be
capitalized as part of the cost of the asset. The associated costs can include things like
freight or transportation costs, installation costs, and the cost of test runs if necessary.
Let's look at an example to make sure you understand first what I mean by
capitalisation. And second, to see how depreciation expense is recorded in this
example, assume the firm buys machinery with the purchase price of five thousand
dollars and pays another one thousand dollars to have the machinery installed and
setup for use in its production plan. Clearly, the purchase price will be capitalized in
record as an asset, as we've seen in previous examples. Cash decreases by five
thousand, and machinery increases by five thousand. The question really centers
around how to handle the one thousand dollars of installation costs. One possibility
would be to expense that one thousand dollars by recording it, as you see here, with a
one thousand dollar decrease to cash in a one thousand dollar expense on the income

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state. However, the thinking is that this cost is more properly thought of as really part of
the acquisition cost of the asset. The machinery won't do you any good if it's not
properly installed and setup.
So those costs are just as integral to buying the machine as the purchase price. Under
that logic, the accounting rules require that the installation costs also be capitalized,
which means that rather than showing the one thousand dollars as an expense, that
immediately reduces net income and retained earnings instead, capitalize the one
thousand dollars by adding it to the machinery account. The result is the machinery is
recorded at a total cost of six thousand dollars, which is the amount that will be
depreciated in future periods. To summarize, capitalisation will add more cost to the
assets, while at the same time showing less expense on the current periods income
state. However, whatever amounts are capitalized will eventually be expense taz. The
firm depreciates its assets, which is what I want to turn to. Now. As I said earlier,
depreciation is an accounting process whereby the total cost of an asset is allocated to
the income statements of the periods in which the firms uses the assets to make sales
and generate revenues. This is just another illustration of the accrual method in action
for expenses, just as the accrual method required revenues to be recognized when they
are earned, not necessarily when the cash is received. So too, with expenses, they
should be recognized when they're incurred or used to generate the revenues
recognized during the period. In this way, expenses are matched with the revenues they
help to generate. When the firm buys machinery, IT's not yet used in the business. So
all the costs are capITalized and no expense is shown. But then as the firm puts the
machinery in use and begins producing and selling its products, it should start to
expense the asset through depreciation. Various methods for computing depreciation
expense are allowed under both you s gap and I f r s we will only look at the most
common approach, straight line depreciation.
Depreciation expense is computed under the straight line method by subtracting the
residual value from the cost and dividing that amount by the estimated useful life of the
asset residual value is an estimate of what the asset will be worth at the end of its useful
life. Both the residual value and useful life must be estimated by management based on
how they intend to use the acid in their business. In our example, we will assume that
six thousand dollars has been capitalized as the total cost of the machinery, and that the
firm estimates a useful life of ten years, at which time the machinery will only have scrap
value, which is estimated to be zero. Depreciation is then calculated as six thousand
dollars divided by ten years or six hundred dollars per year. This is recorded as an
expense on the income statement, reducing that income and retained earnings, and as
a decrease to the machinery account. Since the firm has used up one tenth of the asset,
notice that in this example, i've shown the decrease to machinery by directly decreasing
the machinery account by six hundred dollars. A more common approach to recording
the decrease in machinery is to use a separate valuation account called accumulated
depreciation. The only difference here is that rather than subtracting the six hundred
dollars of depreciation from the machinery account, the depreciation is put into and
accumulated depreciation account that has always presented as a subtraction from the
machinery account on the balance sheet. This is why we refer to it as a valuation
account, since it's used to properly value the machinery at its cost minus any

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depreciation taken. Investors and analysts prefer this disclosure because it provides
some insight into how much of the acid has been used by comparing the amount and
accumulated depreciation with the original cost, both of which are displayed in this
presentation.
Key take ways are that depreciation is not an attempt to show the market value of the
asset. It is not intended to represent the decrease in the market value of the asset, but
rather it is simply a cost allocation process to record the cost of an asset as an expense
as it is being used by the firm. Depreciation does not use any cash. The cash has
already been spent when purchasing the asset. So even though depreciation is an
expense on the income statement and reduces that income, it does not use up any
cash, which is why we often refer to it as a noncash expense. Finally, lots of
management estimation goes into calculating depreciation expense. Investors rely on
the auditor to double check management assumptions to ensure they are reasonable
and consistent with how the firm actually uses the assets and practice. If it appears that
management is using unrealistic assumptions, then the auditor should require that
management used better and more realistic assumptions.

WEEK 2-STATEMENT OF CASHFLOWS

A as you become more familiar with the accrual basis on which the income statement is
constructed, you quickly appreciate the need for a statement that focuses solely on
cash and identifying the sources and uses of cash during the period. Thus, the
statement of cash flow is the third statement, which is needed to complete the
description of a company's financial position and performance. As I said, the purpose of
the statement of cash flows is to show where the firm got cash during the year and how
it was spent. In so doing, it provides an explanation of the change in the cash balance
on the balance sheet from one year to the next. The bottom line figure on the statement
of cash flows, the net increase or decrease in cash should equal the change in the cash
account. As you see here with fasten, all the cash flows are classified into one of three
categories, cash flows related to operating activities, cash flows related to investing
activities, and cash flow related to financing activities, operating activities. Are those
directly related to your primary sales activities? Things like cash received from
customers, cash paid to employees, suppliers, and anyone else that supports your
operating activities? Investing activities capture money spent on fixed assets and
investments in other companies, as well as cash received when these investments are
sold. Financing activities include issuing stock borrowing and repayment loans, stock
buybacks, and the payment of dividends to stockholders. One thing that can be a little
tricky when reading a statement of cash flows is that most firms use what is called the
indirect format for the statement, as opposed to the direct format. These terms, direct
and indirect, refer only to how the operations section is presented.
The investing and financing sections are always presented using the same format. Let
me show you an example. This is what a direct format statement of cash flows looks
like. The operation section is showing line items for the direct cash inflows and cash
outflows, just as happens in the investing and financing sections. In the indirect format,
the only thing that changes is the operation section. Now, instead of showing the

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operating inflows and outflows separately, the operation sections begins with net
income from the income statement and presents a reconciliation of net income to the
actual net cash from operations. Note that the investing in financing sections are
identical. Here are the two operations sections side by side. You should take a minute to
study this to make sure you see that both formats arrive at the same cash flow from
operations of one hundred and eighty five thousand dollars. They're just two different
ways to show the net cash generated or used from operations. Some people prefer the
direct method so they can more easily see the separate amounts of cash paid or
receive. Others prefer the indirect method, because they like the easy comparison
between net income and cash flow from operations, should point out that with the
indirect method, though, most people new to accounting find it hard to understand why
certain items are added back and others subtracted. Well, IT's beyond the scope of this
video to go into any sort of in depth explanation of each line ITem. But suffice IT to say,
they each represent the difference between the way something is captured in that
income based on the accrual method and its actual cash flow, for example, take
depreciation expense. Depreciation, as we seen, is a normal expense on the income
statement that reduces net income. However, it doesn't use any cash. No cash is paid
out when depreciation expense is recognized.
So cash flow from operations will always be more than net income by the amount of
depreciation expense. In order to adjust or reconcile net income to cash flow, then we
must add back depreciation expense. That's a sort of thing that is happening with each
line item. For our purposes. In this segment, your focus, when viewing an indirect cash
flow statement should really be on the relation between net income and cash flow from
operations. One would hope that over time, the pluses and minuses would average out,
and there would be a pretty strong relationship between net income and cash flow. If
cash flow from operations starts to decline, without a similar decline in that income, that
could be a red flag, that the firm is having a hard time collecting cash from its
customers, or even worse, maybe manipulating the financial numbers. The statement of
cash flow is really needed to complete the financial picture of the firm. The balance
sheet lists the company's resources and the claims on those resources at a single point
in time. Thus becomes important to compare the end of the year balance sheet at the
beginning of the year balance sheet to identify changes in to see if and where the firm is
growing. The income statement is necessary to provide more detail on the operations of
the firm, how well IT did during the year. IT's selling ITs products and services. And the
statement of cash flow provides direct insight into where we got our cash and how it
was spent. The key take away is that you cannot rely on any one of these statements
alone to fully evaluate a firm's financial health. You really have to examine all three and
understand the different insights each statement can provide.

WEEK 2-WRAP UP
Okay, so you made it through week two, and these are just some of the key take ways
i'd like you to have from our weeks work. First and foremost, I want you to appreciate
the difference between the accrual basis and the cash basis for recognizing revenues
and expenses. If you think about it, this really all comes about because of the need by
investors and users of financial statements to know how well the firm did for a specific

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point in time, say two thousand fifteen in the problem is our business was going on
before two thousand fifteen is gonna continue beyond two thousand fifty. Not everything
stops and starts with in that calendar year. So this is going to require all kinds of
judgements and estimates on the part of management to figure out exactly how to
define the revenues and expenses that should be allocated to just two thousand fifteen.
And because we do so much business on credit, we extend our customers, credit our
suppliers, extent us credit. But it turns out that the actual transfer of cash isn't really the
key indicator of the underlying activity. And so we create criteria that are a little more uh,
qualitative, like when is the earnings process is complete and one of the expenses been
used to generate revenues. So make sure you're clear on the difference between
accrual basis and cash basis. So yes, there's a lot of judgement and estimates required
to create a set of financial statement. Everything from, you know, is the earnings
process complete to what are the useful lives of my assets or all my customers gonna
pay me? Uh. How many warranty claims am I going to get? They're all sorts of
judgements and estimates that are required to produce these financial statements, and
you must always be on the lookout for them, which means as an analyst or investor,
really any user of financial statements, you've got to read these things with a very
careful and critical hi, you must always be on the lookout
for where are the key judgments being made. And what were the key estimates that
management made in coming up with a revenues and expenses that determine profits?
And do those judgements and estimates look reasonable, or could they have been
made with maybe a bias towards making the company look better than they really are.
That's always the challenge in reading financial statements. In one of the key tools that
we use to help us, uh, do that sort of evaluation is ratio analysis. And that's gonna be
our topic for week three.

WEEK 2-KNOWLEDGE CHECK REVIEW

In this video, I want to walk you through the solution to the first knowledge check of
week to the five questions we did on revenue recognition. In this knowledge check, we
were looking at transactions related to a bookstore, coffee shop bookstore. In the first
one. Pear is the book store sells children's books to a local elementary school during
september on account four eight hundred and fifty. So they collect the cash in october.
Again, under the accrual basis, we recognize revenue when it's earned, not when the
cash is collected. So the sale took place. The uh, books were delivered in september.
So the correct answer there is b all the revenue click recognized in september, nothing
in october, november. Now, if you're doing this on a cash basis, of course, the answer
would be c and you recognize revenue when the cache was received. But that's not
what we do, uh, with accrual basis accounting. So the correct answer is b next, barry
receives a hundred dollars in september from a customer to reserve two copies of a
book that's not due out until october. So this is an advance payment, like a down
payment or deposit from a customer. We get cash. So cash goes up. We can't
recognize revenue yet, because we haven't earned it. We haven't delivered the product
or service that will happen in october. So this is actually a liability to paris. So cash will
go up a hundred and a liability will go up for a hundred. Seems a little odd called a
liability, but not all liabilities are payable in cash. So paris has an obligation to complete

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the sale to the customer in october. That's a liability of ah, a hundred dollars. And then in
october, when the books are delivered, the uh, liability will be reduced in that hundred
dollars will be moved over and recognized as revenue. So the correct answer is c all the
revenue will occur in october when the sale takes place.
Paris coffee shop served meals in october, um, customers paid cash at twelve hundred
dollars for some of the meals. And then another eight hundred dollars of meals were
served in which customers paid with credit cards. So all that is revenue in october
twelve hundred plus eight hundred two thousand dollars, whether their cash or credit,
we treat them the same. That's all october revenue. I don't care when they were
collected, some was collected, uh, uh, that months, um, the next month. Does it matter?
All the revenue in october? Zero in september november said the correct answer is a
now here we have cash coming in in september october for books that were actually
sold on account or on credit in august. So all the revenue should have been recognized
in august. We just have cash coming in september, october, so in august, the company
recognize revenue and they would have shown an accounts receivable for the seven
hundred and fifty dollars. And then in september, when they receive five hundred, cash
will go up and accounts receivable will go down. No revenue to recognize in september
or october, because all that revenue is recognized in august, when the sale took place,
when the books were delivered, when the earnings process is complete. So here, perry
decides to earn a little extra rent revenue by renting out office space for seven hundred
dollars a month. They get a check for three months in advance on october first, twenty
one hundred dollars. This is kind of like a downpayment we just saw earlier. So paris
cash would go up twenty one hundred, and they'd have unearned revenue, a liability for
twenty one hundred that they will earn as the months passed october, november, and
december. So each month, all they can recognize is one month's worth of revenue. So
at the beginning of october first, they would actually have a liability of twenty one
hundred dollars. Then at the end of october,
we would take one month of revenue out of the underlying ability. We were would
reduce under liability by seven hundred and show seven hundred dollars as revenue for
october. And then we do that november in december. So the correct answer is d no
revenue in september, but seven hundred dollars of revenue in october and seven
hundred in november.

WEEK 2-KNOWLEDGE CHECK REVIEW CROSS COUNTRY

WEEK 3-NEW ENGLAND BOART COMPANY

WEEK 3-OVERVIEW
WEEK 3-ASSET MANAGEMENT RATIOS-NEBCO
A once you've made a pass for the income statement, IT's time to move over to the
balance sheet and get some insight into how well the firm is managing ITs operating
assets. The investments it's made to generate sales and net income. We'll start with a
big picture perspective by calculating the asset turnover ratio, by dividing that sales by
total assets. This ratio relate sales to the overall investment made to support and
generate those sales. It tells us how efficiently net code generate sales given its

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investment in total assets. An asset turnover of one point six means that for every dollar
net co invest in assets, IT's able to generate a dollar sixty in sales. Clearly, a higher
number is better. The asset turnover ratio, like all ratios, is only meaningful if the
underlying financial statements properly capture all the asset and liabilities, revenues,
and expenses that the firming curves or has at its disposal for service firms or firms that
rely primarily on their human capital generate revenue. Their reported assets
significantly understate their real assets. Since the firm's work force on its intellectual
capital is not recorded on the balance sheet. In these cases, the asset turnover ratio
becomes less useful. One approach to solving this problem is to substitute the number
of employees for total assets. In any ratio that makes use of assets. In this case, the
asset turnover ratio will become a sales per employee metric, which can be a useful
metric when analyzing service companies. While the asset turnover ratio is a good high
level metric, IT's important to zero in on some of the more important individual assets for
firms that require heavy investment in fixed asset, the fixed asset turnover is a useful
metric calculated by dividing sales by net property, plant, and equipment.
Similar to the asset turnover ratio, it relates the investment in fixed assets to the amount
of sales generated. The fixed asset turnover ratio is most useful when analyzing
companies that rely on significant investments in fixed assets to run their business. And
like the asset turnover, a higher number is better, indicating the companies generating
more sales for each dollar invested in fixed assets. Some of the most interesting asset
management ratios are the working capital ratios. I say that because these three ratios
can have a huge impact on a firm's cash flow position, they focus on inventories,
accounts receivable, and accounts payable. Each of these ratios can be computed as
either a turnover ratio or as a daze ratio. They provide exactly the same information. I
prefer the day's version, because I think it's easier for most of us to think about
inventories, receivables, and payables in terms of the day's it takes to collect on our
receivables or the days it takes to pay our suppliers. But since we're having so much
fun, i'll calculate the ratios both ways for new england boat company. Let's look at the
inventory ratio first. The inventory turnover ratio is calculated by dividing cost of goods
sold by inventory. This tells us how many times our inventory turned over or was sold
during the year. The higher the turnover ratio, the faster we are selling our inventory,
which is a good thing for napco. The inventory turnover ratio is six, computed by
dividing cost of goods sold two million, one hundred thousand by inventory, a three
hundred fifty thousand. Well, since we've already computed the inventory turnover ratio,
the easiest way to compute days and inventory is just to divide three hundred and sixty
five, the number of days in a year by the inventory turnover ratio. If inventory turns over
six times per year, that equates to every sixty one days. This tells us that ned co has
about sixty one days worth of inventory on hand. Or put another way,
it takes nico, on average, sixty one days to sell its inventory of boats once the inventory
is sold. The next question is, how long does it take net code to collect the cash? Let's
turn to the receivables turnover and days, and accounts receivable ratios. To answer
that question. The accounts receivable turnover ratio is calculated by dividing sales by
accounts receivable. This tells us how many times are receive a liz turned over or were
collected during the year. The higher the turnover ratio, the faster we're collecting on our
receivables. And credit sales, which is good, since we need the cash sooner, the better

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for ned co, the receivable turnover ratio, six point nine computed by dividing sales of
three million, one hundred thousand by accounts receivable, a four hundred and fifty
thousand. To convert this two days and receive a blouin and do the same thing we did
with inventory turnover, divide three hundred sixty five by the accounts receivable
turnover ratio to get fifty three days. This means that it takes nap go on average fifty
three days to collect the cash from a customer once they sell about. Well, that may
seem a bit long. Remember what we heard from that goes management. Many
customers were holding off making final payments because the boats weren't
completely finished, something they'll have to fix in the future. Put this together with a
days in inventory. We see that it takes sixty one days for net code, a cell about and
another fifty three days to collect the cash. So net co is out of cash for a hundred and
fourteen days, almost four months. That's a lot for any company, but particularly for a
start up that needs every dollar can get. Being out of cash for four months means net
code needs to get this cash from somewhere else, borrow it, or sell stock, or it could
delay paying its vendors as long as possible. If that's the case,
ned co would like to ask its suppliers to wait a hundred and fourteen days to get paid
until ned cole is had time to sell about and collect from its customer. But of course,
suppliers don't want to wait that long. Well, how long does it take ned cole to pay its
customers? Let's look at it's payable turnover and days in payables ratios. The accounts
payable turnover ratio is calculated by dividing cost of goods sold by accounts payable.
This tells us how many times our payables turned over or were paid during the year. For
napco, the payables turnover ratio is seven, computed by dividing cost of goods sold of
two million one hundred thousand by accounts payable of three hundred thousand the
higher the turnover ratio. The faster we're paying our bills to our suppliers, which is a
good thing for our suppliers, but uses up our cash. This is the challenge for any
company, but particularly for startups. They want to conserve cash by taking as long as
possible to pay their bills. But they also want to maintain good relationships with their
suppliers by paying their bills on time. This is just one of the many delicate trade offs the
successful entrepreneur must figure out. Putting this all together gives us what's
referred to as the cash operating cycle, or the cash conversion cycle. Basically, IT's the
length of time the firm is out of cash due to the time IT takes to sell inventory and collect
cash. And the fact that vendors want to be paid sooner rather than later. Clearly, firms
would like to have their cash operating cycle be as low as possible, meaning they're out
of cash for a shorter period of time and don't have to rely as much on other sources of
financing to finance their working capital. Firms that can effectively manage these ratios
can save themselves significant amounts of cash. How do you do this? Well, for one,
you may work with your suppliers to convert them to more of a justin time supplier. So
you can reduce their investment in inventories without risking stock outs to your
customers.
Or you might work more closely with your customers to see what it would take to get
them to pay more quickly, or maybe even in advance for some of their purchases. You
can all probably think of things you do in your business as to accelerate the conversion
of cash by working with your customers and suppliers. And for the entrepreneur
managing their start up or a growing company, this can be one of their most significant
challenges maintaining an appropriate balance between investing in an inventory,

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paying your suppliers on time, and collecting from your customers as quickly as
possible. For many young firms, this can mean the difference between success and
failure.

WEEK 3-RETURN ON INVESTMENT-NEBCO

WEEK 3-PROFITABILITY RATIOS-NEBCO
WEEK 3-LIQUIDITY AND SOLVENCY RATIOS-NEBCO
WEEK 3-WRAP UP
WEEK 4- NEW ENGLAND BOART COMPANY
WEEK 4-OVERVIEW
WEEK 4-FORECASTING SALES & EXPENSES
WEEK 4-INTEREST,TAXES & CURRENT OPERATING ASSETS
WEEK4-FIXED ASSETS & CURRENT OPERATING
WEEK 4-FINANCING LIABILITIES & EQUITY
WEEK 4-WRAP UP

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