INTRODUCTION TO

FINANCIAL ACCOUNTING

ANTHONY WEBSTER
12TH EDITION
 INTRODUCTION TO
FINANCIAL ACCOUNTING
12TH EDITION

ANTHONY WEBSTER

Copyright © 2014 – 2019, Applied Finance, LLC.

ISBN 978-1-6289-0809-1
 CONTENT HIGHLIGHTS

If you are interested in Check out these examples

Investment Management Evaluating a Prospective Corporate Bond Investment
(Analysts and Portfolio Managers) Chapter 1
The Balance Sheet Valuation Method
Chapter 3
The Collapse of Fannie Mae
Chapter 5
Ratio Analysis with Market Data
Chapter 13
Types of Equity Investors and Investing Strategies
Chapter 13
Investment Banking Strategically Cutting Sales to Improve Profit Margins
Chapter 12
Mergers and Acquisitions
Chapter 11
Hedge Funds Taxation of Athletes and Investment Managers
Chapter 9
Price to Earnings (PE) Ratio and EBITDA to EV Ratio
Chapter 13
Risk/Reward Considerations
Chapter 13
Private Equity Using Journal Entries to Understand the Implications
of Accounting Events
Chapter 4
Taxation of Athletes and Investment Managers
Chapter 9
Financial Leverage and Private Equity Investors
Chapter 12
Entrepreneurship Handling Credit Card Purchases
Chapter 3
Working Capital and Operating Cash Flow
Chapter 13
The Great Recession The Collapse of Fannie Mae
Chapter 5
Bankruptcy Ratio Analysis with Market Data
Chapter 13
The Balance Sheet Valuation Method
Chapter 3
 DETAILED CONTENTS

Chapter

1. Introduction – Why Accounting is so Great

2. Accounting Basics
3. The Balance Sheet
4. Recording Accounting Events
5. Case Study: The Collapse of Fannie Mae
6. Income, Owners’ Equity and Cash Flow Statements
7. Entity Typology, Inventory and Cost of Goods Sold
8. SGA, Depreciation Revisited and Taxes
9. Case Study: Taxation of Investment Managers and Athletes
10. Cash Accounting
11. Comprehensive Accounting Example
12. Financial Statement Analysis I: Information and Insights Derived From
Financial Statements
13. Financial Statement Analysis II: Ratios Derived From Market Data and
Financial Statements
14. Sources and Uses of Cash and the Indirect Cash Flow Statement
15. Afterword

Appendix: Practice Problems

Outline: Quick Review and Study Guide

About the Author

WHY ACCOUNTING IS SO GREAT

CHAPTER 1
 INTRODUCTION

WHY LEARN ABOUT ACCOUNTING?

Knowledge of accounting and finance provides a helpful framework for viewing and
understanding many aspects of modern life. An understanding of both subjects is needed to
solve many problems faced by engineers, managers, entrepreneurs, and investors.

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

WHY USE THIS BOOK TO HELP YOU LEARN

ACCOUNTING?
Aside from my vain and baseless hope that this text would prove as compelling and lucrative as a
Harry Potter novel, I wrote it first and foremost to help students in my Introduction to
Accounting and Finance course at Columbia University master a subject that is very different
from those encountered in their other classes. As I reviewed texts for the course, I found many
that were helpful but seemed needlessly obfuscated, wordy, or non-topical1. Other books seemed
too narrow in their scope – focused only on the mechanical aspects of accounting, as applied
only to industrial companies. I’ve tried to avoid these pitfalls in this book by using several
straightforward techniques:

· Keeping it short and topical.

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

· Explaining accounting’s typology and its relation to business typology.

Most introductory accounting texts assume that all entities are of the industrial type, featuring
inventory and lots of sales-generating property, plant and equipment (PPE), but with no
revenue-creating intangible assets (such as loans originated), and no revenue generated from

1. There are of course exceptions to this, including for example the excellent Core Concepts of Accounting text by
Breitner and Anthony. This book is a bit too basic for my courses’ needs.

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 2

 non-accounting assets (such as human capital). This is nuts in an economy where non-
industrial entities contribute more than 35% to GDP2.

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

· Providing material that is helpful to entrepreneurs.

As an instructor and consultant, I've helped a variety of entrepreneurs implement scalable
accounting systems and create financial statements that are presentable to seed funders and
venture capitalists. I've also noticed that most accounting treatises don't address recording
and reporting issues that entrepreneurs routinely confront, such as how to account for PPE
purchases made with their companies' credit cards. Throughout this text, I've presented
accounting issues that early-stage firms can expect to encounter, and examples showing how
to deal with them.

· Presenting simplified examples from the Investment Banking, Private Equity and Investment
Management industries.
This book is written for people who need to understand financial accounting, but do not
intend to become professional accountants. This audience includes future CFOs, economists,
investment bankers, private equity advisers and investment managers. These professionals
can expect to encounter mergers, LBOs and spinoffs during their careers. They should
understand ratio analysis as well as ratio-based and Balance-Sheet-based valuation methods.
Accordingly, the text provides straightforward examples covering the accounting of these
transactions and analysis methods.

· Assuming a computerized world.

I assume throughout the book, as shown by widely-utilized programs such as QuickBooks
and Peachtree, that basic accounting is well modeled as a rule-based system of recording and
reporting an entity’s economic events. Accordingly, I’ve eschewed some by-hand learning
tools – like T Accounts – in favor of more spreadsheet and database-oriented aids, such as
Transaction Tables (as defined in the Accounting Basics chapter).

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

2. Bureau of Economic Analysis: http://www.bea.gov/industry/gdpbyind_data.htm

Bureau of Labor Statistics: http://www.bls.gov/iag/tgs/iag_index_naics.htm

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 3

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

· Judiciously simplifying some definitions and rules.

Anyone who has delved into the Financial Accounting Standards Board's (FASB's)
definitions and rules for financial accounting in the U.S. knows that they are extremely
complex. For example, FASB announced in May 2014 a set of rules governing how and
when firms should recognize revenue, which totaled more than 900 pages!3 To keep this text
short and readable, I define terms and explain rules as they apply to a plurality of accounting
situations, while omitting many exceptions and nuances. For example, I suggest declaring
revenue after goods have been delivered (and ownership has been transferred to the
customer) or after services have been provided, instead of explaining the 900 pages worth of
revenue-related contingencies outlined by FASB.4

· Personalizing the text’s voice

Unlike most textbooks on any subject, this book is largely written in the first person. It is
also sprinkled throughout with real-world commentary and anecdotes5 based on my daily use
of accounting and finance to assess the strength of potential investments for my firm’s
clients.

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

3 New Accounting Rules to Affect How Companies Book Revenue, Michael Rapoport, The Wall Street Journal,
May 28, 2014.
4 An excellent tabulation and interpretation of FASB's rules is presented in the Miller/CCH GAAP Guide. Print
and eBook versions are available at www.cchgroup.com.
5. An example of a great text that successfully uses first person voice to engage readers while having them quickly
master a subject is Robert Higgens’ Analysis for Financial Management. I strongly recommend this book to anyone
who wants to learn Corporate Finance.

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 4

 EXAMPLE: EVALUATING HCP'S BONDS
Let’s work through an example showing how a very basic understanding of accounting reports,
some knowledge of current events, and a bit of common sense can help you make smart
investment decisions.

Consider Healthcare Properties (HCP):

HCP is a Real Estate Investment Trust (REIT)
in the health and wellness industry, which
acquires, develops, leases, sells, and manages
healthcare properties.

The company is well diversified by

geography and business line. It operates in
California, Illinois, and Tennessee, and is
headquartered in San Francisco. HCP operates
in the medical office, hospital, and life
science segments of healthcare real estate.

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

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

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

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 5

We can compare expected returns-on-investment for bonds issued by the Treasury and HCP
without any knowledge of accounting or finance. Looking in the Treasury bond market place, we
find a treasury bond maturing on September 15, 2009, offered at a price of $100 per bond, with a
maturity payout on 9/15/09 of $100 plus $0.42 interest.

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

Bond What We Get / What We Pay

HCP $102.80 / $ 94.5 = 1.0878
T-Bond $100.42 / $100.0 = 1.0042

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

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

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

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

Looking at things qualitatively, we note that even in a terrible economy, demand for medical
offices, hospitals, and laboratories is almost certainly not going to collapse. In fact, some sectors
of the medical industry would probably see an increase in stress-induced demand for their
services during periods of extreme crisis.

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

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

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 6

 The most important portions of HCP's
Balance Sheet, for short-term bond
investors like us, are highlighted in green
and yellow.

Current Assets (CA) are cash and assets

that can be converted to cash within a year.
Current Liabilities (CL) are obligations
that must be paid within a year. (Note that
HCP's 9/15/09 bond maturity payment is,
of course, listed on the Balance Sheet as a
CL). Assets and liabilities shown in gray
will be used, converted to cash, or paid off
over a long time frame, and are therefore
not crucial to determining if HCP will meet
its bond obligation on 9/15/2009.

This Balance Sheet shows us that HCP's

current assets are much larger than its
current liabilities ($1,978MM >>
$767MM), meaning that, as of 12/31/2008,
the company was in a great position to
meet its current bond maturity, as well as
its other short-term obligations.

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

So far so good for HCP's bond prospects. But what if HCP is burning through cash at a horrific
rate for some reason? (This can happen – General Motors, for example, found a way to burn
through $5BB per quarter during 2008.) HCP's Balance Sheet shows information only as of
12/31/2008 and does not speak to this issue. To check for this potential problem, we'll review the
company's recent Cash Flow Statements.

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

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 7

2. Investing cash flows record the net flow of cash from purchases and sales of long-term
assets, such as property, plants and equipment (PPE), including long-term maintenance and
upgrades.
3. Financing cash flows measure cash flows to and from HCP’s financial stakeholders,
including shareholders (the firm's owners) and lenders (such as holders of HCP's 9/15/09-
maturing bonds, bank lenders, etc).
Here are HCP's Condensed Cash Flow Statements for its last four quarters:

The statements show us that:

 HCP's day-to-day operations (its Operating Activities) have been consistently generating
cash during the past year.
 Its investments in the purchase and maintenance of PPE use much less cash than its
operations generate. During Q4 for example, (HCP's “worst” quarter from an investing
cash-flow perspective), the company seems to have spent just $29MM on PPE, while its
operations generated $133MM.
 HCP has been consistently returning cash to its stakeholders – probably in the form of debt
repayment, dividends to shareholders, and/or share buybacks. For example, HCP's Q3
financing flow of ($80)6 could could be comprised of a $50MM debt payoff, a dividend
payout of $10MM, and $20MM of share-repurchases. (We would again need to look more
deeply to find exact amounts). All of these transactions suggest that HCP has had no need to
raise cash from equity or debt stakeholders. This is good news for potential short-term-
bond-investors like us.

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

We can now summarize our independent analysis of HCP's bond as follows: The healthcare
industry is unlikely to collapse, irrespective of the depth or duration of the great recession. Given

6 In accounting and finance, negative numbers are often written inside parenthesis instead of being preceded by a
minus sign. IE: ($80) instead of -$80.

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 8

HCP's financial strengths as shown on its recent Balance Sheet and Cash Flow Statements, it
seems highly probable that it will meet its 9/15 bond obligation with ease. The bond's price is
probably depressed because of the generalized fear in the stock and bond markets so prevalent at
this time (3/16/2009).

So we probably want to buy this bond. To be sure, we would make several more commonsense
checks. For example, we'd perform a careful scan of company-related news (again easily
completed with a free Yahoo or Google company news search). We'd want to be on the lookout
for near-term-future problems that may cause HCP to bleed cash, even though HCP has not listed
these problems as liabilities. (HCP has the right not to list such items if, in agreement with its
accountant, the potential problems have a small probability of being realized. An example would
be a forthcoming Medicaid audit of a large HCP customer, which might result in the tenant going
out of business and ceasing rent payments).

Epilogue
Using its positive cash flow and large cache of current assets, HCP easily raised the $103MM
needed to meet its 9/15/2009 bond maturity. Bondholders who purchased on 3/16/2009 at
$94.50 per bond enjoyed an 8.8% return in just six months7, or 18.4% per year on an annualized
basis. (Measuring returns on an annual basis – IE: asking “what would this investment return per
year?” – is common because it provides a nice, apples-to-apples method of comparing
investments of differing durations. We will develop the math for this in a later chapter).
Purchasers also enjoyed this high return with little risk. Unlike the myriad factors that move
stock prices sharply up or down over six month periods, the upside return on this investment was
guaranteed unless HCP went bankrupt, and our analysis proved that to be a very low-probability
event.

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

7 ($102.80 - $94.5) / $ 94.5 = 0.088 or 8.8%

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 9

CHAPTER 1 – WHY ACCOUNTING IS SO GREAT PAGE 10
ACCOUNTING BASICS

CHAPTER 2
PRIMARY CHARACTERISTICS OF ACCOUNTING
Warren Buffet's famous description of accounting “the language of business” is apt. Accounting
has a unique vocabulary and expressive structure, designed to provide information on entities
and to help understand their economics. A more specific way to think about accounting is as a
universally accepted, largely rule-based method of identifying, recording, and reporting an
entity's financial information.

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

ACCRUAL VS. CASH ACCOUNTING

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

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

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

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

The notion of accruing is fundamental to Accrual Accounting. We will use it in several ways,
such as:
 HCP's accrued Accounts Payable liability was $308.1MM on 12/31/2008

CHAPTER 2 – ACCOUNTING BASICS PAGE 2

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

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

Another form of accounting, called Managerial Accounting is centered around questions like
“How much of an entity's lighting bill should be charged to its HR department versus its
accounting division, when both groups share the same space?” Managerial Accounting
information is prepared specifically for a company's managers, and not for other stakeholders.

Both Accrual Accounting and Cash Accounting are considered branches of Financial
Accounting. This text covers only Financial Accounting.

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

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 3

Solution:

CHAPTER 2 – ACCOUNTING BASICS PAGE 4

 CONCEPTS GOVERNING ACCOUNTING
There are twelve key concepts that provide a framework for Accrual Accounting:
1. Accrual
2. Money Measurement
3. Duality
4. Entity
5. Going Concern
6. Cost
7. Accounting Period
8. Conservatism
9. Realization
10. Matching
11. Consistency
12. Materiality

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

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

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

The Money Measurement Concept says to consider

only items and transactions that can be conveniently
measured and reported in cash ($) or another currency.
So Apple, for example, records its cash cost of buying
1,000 chip-sets, and the amount it pays Tim Cook per
year. Apple does not report Tim Cook’s value to
Apple, although the amount is substantial, because it’s
difficult to measure his value. (50 randomly chosen
Apple employees would probably provide 50 unique
estimates of Cook's value to the firm). Similarly,
Apple does not report the value of its logo, even
though it’s clearly worth a fortune.

CHAPTER 2 – ACCOUNTING BASICS PAGE 5

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 6

 IMPORTANT ACCOUNTING QUANTITIES
The three most important Financial Accounting quantities are Assets, Liabilities, and Owners'
Equity, or simply Equity.

ASSETS
Assets are valuables that are owned or controlled by an entity, including specifically: cash, things
to be converted to cash, and things used to generate cash. Apple, for example, has these assets:
 Functioning iPhones held in its warehouses
(Called “Inventory”)
 Invoices delivered to AT&T that have not been paid
(“Accounts Receivable”)
 Land and buildings owned by the company
(“Land,” and “Property, Plant and Equipment”)

Apple does not consider these items assets:

 200 Macs that have been completely destroyed by rain
(These are by definition no longer valuable)
 The head of its R&D department
(Apple may have an employment contract with her {which would be an asset}, but
obviously the company does not own this employee)

HCP's assets include:

 Its cash
 Property plant and equipment
(Including its buildings, and the trucks/lawnmowers/etc. it uses to maintain its buildings)

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

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

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 7

Example liabilities of Apple's include:
 Unpaid invoices from Foxconn
(Called “Accounts Payable”)
 The outstanding mortgage balance on its headquarters building
(“Mortgage” or “Debt”)
 Salaries earned by its employees that have not yet been paid
(“Accrued Salary” or “Accrued Liabilities”)

Liabilities of HCP are:

 Unpaid invoices owed to its heating oil supplier.
(“Accounts Payable”).
 Bond principal and interest owed.
(“Debt” and “Accrued Interest” respectively).
 The unpaid balance of the loan it took out to purchase the truck mentioned above.
(“Debt”).

OWNERS' EQUITY
Owners' Equity (also called Equity) is defined to be an entity's total assets minus its total
liabilities. IE:
Equity ≡ Assets – Liabilities1 22j)2
With this definition, equity is also mathematically equal to:
All the cash infusions put into the company by its owners since the firm's inception, plus all the
Net Income earned by the firm over its lifetime (or revenues minus expenses over the firm's life),
minus all the dividends paid to the firm's owners, since the entity was created.

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

Equity = Σ Cash Infusions by Owners
+ Σ Net Income
- Σ Dividends Paid to Owners
(Where “Σ” means the sum over entity's entire life).

By formalizing and abbreviating terms:

 Cash infusions by owners is formally called Paid in Capital and abbreviated as PIC.
 Net Income is abbreviated as NI
 Dividends paid to owners are formally called Dividends, and abbreviated as Div.
We can further shorten the above equality into:
Equity = Σ PIC + Σ NI - Σ Div 22k)

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 8

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

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

Speed Learning Tip:

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

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

Relationship Between Owners' Equity and the Value of a Firm

The definition of Owners Equity,
Equity ≡ Assets – Liabilities
suggests that this quantity is closely linked to the value of a firm. By subtracting a firm's
financial obligations (liabilities) from its financial valuables (assets), we are left with a pile of
stuff (say “net assets”) that could be sold, and the proceeds could be distributed to the firm's
owners (usually called its shareholders). In this sense, equity is an approximation of what the
firm is worth to its owners, or an approximation of the value of the entity.

I say “approximation” because equity, as defined for Financial Accounting, misses the value of
an entity in several ways. First, the value of the assets as recorded may not represent the actual
amount they would sell for. Apple’s iPhone inventory, for example, is recorded at the cost of the
phones – hopefully they could be sold for much more than this. Also, if HCP bought some of its

CHAPTER 2 – ACCOUNTING BASICS PAGE 9

buildings during 2007 (the height of the real-estate bubble), their value is probably much less
than their cost.

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

Because of these issues, it’s safe to say that equity, as measured by Financial Accounting, is not
usually a true representation of an entity's worth. However, by altering a firm's equity value to
account for these quirks, we can compute a pretty good valuation of many firms. The Balance
Sheet Valuation Method (covered in the next chapter) aims to estimate the worth of an entity by
using this process.

CONCEPTS GOVERNING ACCOUNTING, CONTINUED

Recall our list of Financial Accounting concepts:
1. Accrual
2. Money Measurement
3. Duality
4. Entity
5. Going Concern
6. Cost
7. Accounting Period
8. Conservatism
9. Realization
10. Matching
11. Consistency
12. Materiality

Now is a good time to cover the Duality Concept, as it relates directly to the relationship
between assets, liabilities, and equity. The Duality Concept states that:
Assets = Liabilities + Equity 22q)
is true at all times, under all circumstances.

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 10

The duality equation has two important implications. First, change in assets over any time
period equals change to liabilities plus change in equity over the same period. IE:
Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity), where: 22m)
Δ(Assets) = AssetsT1 – AssetsT2, etc.
(“ Δ” is pronounced “delta,” and means “change to” or “change from one time to
another”).
Δ(OE) = Δ(PIC) + Δ(NI) - Δ(Div)
Δ(NI) = Δ(Revenue – Expense)
Equation 22m) is called the delta form of the Fundamental Accounting Equation 22q). It is as
important as the equation 22q) form.

Second, every accounting event will have a dual impact on an entity's accounting records. Every
time a company experiences an accounting event (ie: a micro-economic event), its assets,
liabilities and/or equity will change such that equation 22m) holds:
Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity)
Clearly, at least two non-zero changes are required for this form of the duality equation to be
satisfied. For this reason, Accrual Accounting is often called a “double-entry” accounting
system.

CHAPTER 2 – ACCOUNTING BASICS PAGE 11

 RECORDING ACCOUNTING EVENTS
Accounting events are anything that cause a change in assets, liabilities, or equity. For a given
entity, accounting events are usually the same thing as microeconomic events. For any
accounting event,
Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity)
will hold true, and we will use this to help us record accounting transactions.

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

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

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

1. The company is formed.

2. The owners pay in $10,000 (PIC) for 10,000 shares.
3. The company buys $5,000 of furniture and computers. It receives an invoice for the
purchase but does not pay the invoice at this time.
4. The firm provides $8,000 in consulting services, and invoices customers $8,000. Customers
paid $4,000 cash at time of invoicing, and are expected to pay the remaining $4,000 within
60 days.
5. The company incurs and pays salary expense of $3,000, in cash.
6. The firm incurs and pays rent expense of $1,000, in cash.
7. The company pays its owners $2K dividend (“K” stands for thousand).

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 12

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

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

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

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

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

Event 3: Furniture and computers are considered part of Property, Plant and Equipment, PPE,
or Net PPE. Unpaid invoices are recorded as liabilities called Accounts Payable or AP for short.
Event 4: Once WEA provides (completes) the $8,000 of services, the firm declares this as
Revenue. The recording of revenue is balanced by two assets of $4,000 each. When a company
issues an invoice, it generates an Accounts Receivable asset.
Events 5, 6, and 7 are more straightforward. You may check your entries for these events, as
well as for events 3 and 4, by reviewing the completed table below. Note that at the end of Q1,
WEA's total assets equal its total liabilities plus its total equity.

CHAPTER 2 – ACCOUNTING BASICS PAGE 13

Solution:

Notes:
 Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity) holds true for each transaction, and for the
total changes recorded during the period.
 I title the PPE-related Account Payable as “AP (for PPE)” rather than simply “AP” to help
simplify recording the future cash flow associated with this purchase. When WEA pay's off
the AP, it will need to know that the payment was for the purchase of PPE, rather than for
monthly rent or other day-to-day expendatures. We will cover the distinction carefully when
we learn to create cash flow statements.

CHAPTER 2 – ACCOUNTING BASICS PAGE 14

 MORE MEANINGS OF
ASSETS = LIABILITIES + OWNERS’ EQUITY
One reason the Fundamental Accounting Equation is so fundamental is that, in addition to
providing the framework for recording accounting events, it helps us characterize the financial
structure of an entity in several different ways. Here are three example ways to broaden your
understanding of Assets = Liabilities + Equity:

1. The cost of an entity’s resources (assets)

= the amount financed by creditors (liabilities)
+ the amount financed by owners (equity: paid in capital minus dividends)
and by operating the business (equity: net income)

2. Uses of capital (assets)

= Sources of capital (liabilities and equity)

3. The amount invested in entity’s resources (assets)

= creditors’ claims (liabilities)
+ owners’ claim to leftovers (equity)
(This form is especially helpful when a company declares bankruptcy. When a company
goes bankrupt, creditors are paid off first, and then equity-holders are paid if anything is
leftover for them).

CHAPTER 2 – ACCOUNTING BASICS PAGE 15

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

A second, worse problem with accounting terms is that some words have ambiguous meanings,
which are difficult to resolve. For example, the “price to earnings ratio” (PE ratio) of a stock
may refer to a ratio taken on a historical basis, a projected basis, or an average of historical and
projected numbers. Problems like this may be impossible to resolve without questioning the
person using the ambiguous term.

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

Speed Learning Tip:

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

CHAPTER 2 – ACCOUNTING BASICS PAGE 16

THE BALANCE SHEET

CHAPTER 3
 CONCEPTS GOVERNING ACCOUNTING

Before jumping into a detailed discussion of Balance Sheets, let’s cover three accounting
concepts that will help us understand how these reports work.
1. Accrual.
2. Money measurement.
3. Duality.
4. Entity.
5. Going concern.
6. Cost.
7. Accounting period.
8. Conservatism.
9. Realization.
10. Matching.
11. Consistency.
12. Materiality.

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

Effect on Effect on
Event Entity: Firm’s owner
Sole owner moves -$100 Cash, No net effect
$100K from her firm to her -$100 Equity
personal checking account.

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

CHAPTER 3 – THE BALANCE SHEET PAGE 2

Before covering the Cost Concept, recall that an entity’s assets are:
§ economic resources,
§ cash, anything that will be exchanged for cash, or anything that helps the firm generate
cash, and
§ things that are owned or controlled by the entity.

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

An example of an asset that is valued at cost permanently is undeveloped land held for
investment or later use. Unlike the price of a publicly-traded stock, the market value of an
entity’s land cannot be looked up quickly on a transparent exchange. Additionally, while the
equity market provides a consensus value for the price of SPY shares, the cost of a piece of land
will vary by appraiser, with a low probability of all appraisers pricing the land equally. The
difficulty of quickly determining a universally agreed price is one reason that financial
accounting measures land at cost. For most assets, financial accounting aims to strike a balance
between ease of lookup and market-value accuracy, but it usually errs on the side of a quick and
easily-verifiable lookup.

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

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

This situation is described as valuing assets at “the lower of cost or market value,” and is most
commonly seen in assets such as inventory, which describes an entity’s products waiting to be
sold. For example, say Blackberry has recently paid Foxconn $100 per assembled smartphone
for a bunch of Blackberry Z10 devices. On purchase, Blackberry records the phones at $100
each in its inventory account. Soon after these lame devices go on sale, AT&T, Verizon and
CHAPTER 3 – THE BALANCE SHEET PAGE 3
Sprint report that consumer demand for them is very low, and that they will only pay $75 per
Z10. On hearing this news, Blackberry would write down the value of its remaining inventory to
the market value of $75 per phone.

CHAPTER 3 – THE BALANCE SHEET PAGE 4

 FINANCIAL STATEMENTS
As noted above and in the previous Why Accounting is so Great chapter, accounting information
is summarized in reports, called “Financial Statements.” The primary statements are the Balance
Sheet, Income Statement, Statement of Cash Flows, and Statement of Owners’ Equity.

For a given time period (monthly, quarterly, yearly, etc) all financial statements can be created by
drawing on the complete history of an entity’s accounting transactions from inception.
Statements may also be constructed from a firm’s most recently-reported financial statements
and all its accounting transactions for the current reporting period. The first method is typically
used by accounting software packages such as Quickbookstm or AccountingBasicstm. The second
method is much less tedious to perform manually, and it is a great method for learning
accounting. It will therefore be our method of choice in most cases.

Here is a bullet-point summary of the four key financial reports, outlining their missions. The
Balance Sheet information is shown in boldface, as we will cover it first.

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

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

Statement of owners’ equity:

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

Statement of cash flows:

 Reports the flow of cash only over a period of time.
 Sorts these movements into operating, investing, and financing categories.
 Like the Income and Owner’s Equity statements, it’s also a flow report, making the Balance
Sheet our only snapshot or level report.

THE BALANCE SHEET

As noted above, the Balance Sheet reports cumulative amounts of assets, liabilities and equity at
a single point in time, and it preserves duality. A third Balance Sheet mandate is to provide some
measure of detail for assets and liabilities, and to report equity as a) a simple total, b) Paid in
Capital + Net Income – Dividends, or c) Paid in Capital + Retained Earnings (where Retained
Earnings = Net Income – Dividends).

CHAPTER 3 – THE BALANCE SHEET PAGE 5

With these requirements in mind, let’s try to create a Balance Sheet for WEA’s first quarter of
operations (as covered in Why Accounting is so Great chapter). Recall WEA’s Transaction Table
for Q1:

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

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

Assets Liabilities Equity
$17 $5 $12

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

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

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

CHAPTER 3 – THE BALANCE SHEET PAGE 6

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

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

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

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

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

CHAPTER 3 – THE BALANCE SHEET PAGE 7

Here are some important things to remember about this and all Balance Sheets:
 Balance Sheets report total assets, liabilities, and equity at the end of a period. Total means
all items are measured cumulatively from the inception of the firm.
 WEA's EOP account balances, for each account, are computed as:
EOP balance = BOP balance + Σ changes in period
In general, adding BOP balances is necessary to capture the cumulative changes in each
account measured from the firm’s inception. In our example, all BOP balances were zero,
because this was the first period of the firm's existence.

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

The Balance Sheet tells us that, As of EOQ 1, WEA:

 Had $8K cash.
 Expected to get $4K more “soon,” as seen by Accounts Receivable (AR) = $4K.
 Owned property, plant and equipment with a net book value of $5K.
 Owners invested $10K in the company.
 Needs to pay its invoice of $5K.
 Total cumulative “Net Income” (NI) of the company is $4K.

WEA’s EOQ 1 Balance Sheet doesn’t tell us several things we might like to know, including:
 How “soon” does it expect to receive cash payment for its $4K of Accounts Receivable?
 How old is its property, plant and equipment, and what is its total wear? (net PPE ≡ cost –
wear).
 How quickly will its AP liability be paid?
 How much did each individual owner invest in WEA in order to reach the $10K total?
 What were the company’s revenue and expense that yielded Net Income of $4K?

Answers to these questions come from several sources, including:

 The “Notes” accompanying WEA’s financial statements.
Whenever a firm produces a set of financial statements, it is required to prepare an
accompanying set of written notes (called formally “Notes” accompanying the financial
statements”) that provide backup detail for the numbers in the statements. In WEA’s case,
the notes would explain, for example:
 The firm’s Accounts Receivable is expected to be paid within 60 days.
 Invoices (AP) are usually paid within two months of receipt.
 The Statement of Owners’ Equity
This financial report provides detailed information on the firm’s equity accounts. For WEA,
it would show that each of WEA’s two owners invested $5K in the firm.

 The Income Statement

CHAPTER 3 – THE BALANCE SHEET PAGE 8

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

THE BALANCE SHEET VALUATION METHOD

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

Step Task

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

2. Replace the costs of the firm's assets with the market values of these items.
3. Add value of any assets that are not included on the entity's accrual balance sheet.
(This includes brand values, patents, etc.)
4. Compute: Assets(market value {mv}) = Assets(accrual) +/- Adjustments
5. Recall that liabilities are almost always recorded at market value, and compute:
Equity(true) = Assets(mv) – Liabilities
Equity(true) is considered to be a decent approximation of the firm's value to its owners.

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

b) Determine the marketplace's view of the value of HCP's equity. (Warren Buffet might say
this as “determine what 'Mr. Market' believes the firm is worth”). This is easily done by:
i) Looking up the price-per-share of HCP, and the total number of shares outstanding.
(Both are available at Yahoo Finance or Google Finance).
ii) Noting that, if we own all the outstanding shares, we own the entire firm.
iii) Computing Market Price of Firm = Price-per-Share * Number of Shares Outstanding.
c) Compare the Market Price of HCP to Equity(true). Then, if the Market Price of HCP was much
less than our estimate of the firm's value (Equity(true)), then we probably would want to buy
some shares of HCP stock.

What is Wrong with This Picture?

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

CHAPTER 3 – THE BALANCE SHEET PAGE 9

In practice, it’s difficult to use the Balance Sheet Valuation Method in real situations for several
reasons. First, transforming a company's assets from cost-basis to market values is not easy. In
HCP's case, we would have to know the market value for each of its medical office/hospital/lab
buildings. These values can only known for sure when the buildings are actually sold. Second,
estimating the value of things like logos or a company's brands is hard to pin down (which is a
big reason why these quantities are omitted from the Financial Accounting system). Finally, any
Balance-Sheet-based assessment method – which necessarily considers assets, liabilities and
equity at a single point in time – does not usually work for very quickly growing firms, whose
Balance Sheets are inexorably expanding.

Legal Applications – Chapter 7 Bankruptcy

The Balance Sheet Valuation Method is used in Chapter 7 Bankruptcy proceedings, where firms’
are shuttered and their assets are sold to pay off their liabilities. Usually in these cases, a firm’s
liabilities are greater than the market value of its equity, and a bankruptcy judge decides how
much each creditor will be paid. Shareholders (equity owners), who do not have contracts or
invoices promising any payments, are at the bottom of the pecking order. They are guaranteed to
get nothing if a bankrupt firm’s liabilities are greater than the market value of ts assets.

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

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

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

CHAPTER 3 – THE BALANCE SHEET PAGE 10

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

The fatal flaws of this analysis are that WEA’s Balance Sheet assets are reported at cost or cost-
minus-wear, and some assets (like WEA’s brand value) are not reported at all. As we saw in the
previous chapter, the Balance Sheet Valuation Method aims to create a better estimate for the true
value of the firm’s equity by correcting for these problems. Here is a reminder of how the
method works:
1. Recall that Equity(accrual) = Assets(accrual) – Liabilities
2. Replace accrual accounting’s measure of WEA’s reported assets with their market values.
3. Add the value of any assets that are not included on WEA’s accrual Balance Sheet (IE: the
awesome power of the WEA brand, or the value of any patents it may hold). Then:
Assets(market value) = Assets(accrual) +/– these adjustments.
4. Apply: Equity(true) = Assets(market value) – Liabilities

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

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

Assets(true value) Liabilities Equity(true value)

Cash $8K AP $5K Computed as
AR $4K Assets - Liabilities
PPE $0K

Total $12K $5K $7K = $12K - $5K

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

The Balance Sheet valuation method is a great way to estimate the worth of many entities. This
said, it is often difficult to apply in practice because the market value of many assets is difficult
to estimate accurately. The method also does not work well for fast growing firms, whose
adjusted balance sheets do not capture their ongoing values. These problems are discussed more
thoroughly in the Financial Statement Analysis II chapter of this text.

CHAPTER 3 – THE BALANCE SHEET PAGE 11

 A DETAILED LOOK AT
A LARGE COMPANY’S BALANCE SHEET

Lets look in-detail at a Balance Sheet of Healthcare Properties (HCP), the healthcare REIT we
examined in Why Accounting is so Great chapter. HCP’s operations are more complicated than
WEA’s, and therefore its Balance Sheet contains many more quantities. Here is HCP’s balance
sheet for EOY 2009, with its assets emphasized:

At the risk of being extremely boring and repetitive, let’s remind ourselves what assets are before
looking carefully at each of HCP’s. Recall that assets must:
 Be economic resources.
(Resources that will provide monetary benefits, such as cash, things to be converted to cash,
or items used to generate cash.
 Be controlled by the entity.
 Have a conveniently measurable cost at time of their acquisition.

Another way to think of assets, which often helps to clarify the accounting characterization of
micro-economic events, is:
 Any balance sheet item that, if converted to cash today, would bring cash to the entity.
We will see how this view of assets works shortly.

CHAPTER 3 – THE BALANCE SHEET PAGE 12

CURRENT ASSETS
Notice that HCP’s Assets are separated into Current Assets and all other Assets. Current Assets
are defined as either:
1. Cash and Cash Equivalents, or
2. Other assets that HCP intends to convert to cash or to consume within one year of the
Balance Sheet’s snapshot date.3

The first Current Asset listed for HCP is Cash and Cash Equivalents. Cash Equivalents include
investments in Money Market funds and other “demand deposits”. Demand deposits have
virtually no risk of losing their value, and may be immediately converted to cash at any time.
Certificates of Deposit (CDs), unlike Money Market funds, are not Cash Equivalents, because
CD investors may only receive their initial investment (“principal”) back at a certain time, unless
they pay an early-repayment penalty.

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

Marketable Securities are readily marketable investments that the company expects to convert to
cash within a year. Examples include:
 A one-year Treasury Bill.
 A six-month CD.
 IBM bonds maturing in six months.
 Shares of GE stock to be sold in one month.

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

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

Notes Receivable represents a set of short agreements (contracts), signed by an entity’s

customers, affiliates or acquaintances, pledging to pay a certain amount to the entity within a
certain time. Note agreements typically call for payment of the total amount owed (the
principal), plus interest. The principal owed is recorded under Notes Receivable, while any
Note interest that is accrued-but-not-paid is recorded separately as Accrued Interest Receivable.

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

CHAPTER 3 – THE BALANCE SHEET PAGE 13

The time period of a Note agreement may be for greater than one year, implying that some Notes
may not be current assets. (Notes to be repaid in more than a year would be Long-term Assets).

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

Prepaid Expenses represent, logically enough, an entity’s prepayment of future expenditures.

Future expenditures associated with Prepaid Assets may be due in more than a year, so like Notes
Receivable, these assets may be either short-term or long-term.

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

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

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

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

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

LONG-TERM ASSETS
Long-term Assets are any assets that are not Current Assets. These generally fall into two
categories:
1. Assets that will be converted to cash, but not within a year.
Examples include long-term equity investments, and unimproved property, slated for
development in several years.

CHAPTER 3 – THE BALANCE SHEET PAGE 14

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

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

Long-term Investments are investments that an entity intends to hold for more than a year.
Examples include:
 A two-year Treasury Bond.
 A three-year CD.
 IBM bonds maturing in thirteen months.
 Shares of GE stock that the entity has no foreseeable plans to sell.

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

Land includes undeveloped and unimproved parcels. (Land under and around an entity's
buildings is the Property portion of Property, Plant and Equipment). These, along with land
under and around buildings, are recorded by Financial Accounting at cost when purchased, and
normally keep this value for as long as the entity owns the property. If a parcel of land clearly
declines in value below its purchase price, the owning entity would write-down the carrying
value to the current market price. (Conversely, if the land’s price subsequently rose, the property
value would not be marked back up).

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

Net Property, Plant and Equipment (also Net PPE or Net Fixed Assets) includes items that are
tangible, long-lived, and used to produce goods or services that generate cash inflows. “Net”
acknowledges that these items, except for property under and around buildings, are recorded at
cost minus wear. (This wear is called “accumulated depreciation.” We will cover it in-detail in a
future chapter). PPE not qualified as “net” usually describes the total amount paid, without
considering wear incurred to the Balance Sheet date. Examples of an entity’s PPE include: its
buildings and the land under them, machinery, trucks and cars, furniture, and some (long-lived,
relatively expensive) computers.

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

CHAPTER 3 – THE BALANCE SHEET PAGE 15

When an acquiring entity (the acquirer) purchases a target firm, it puts the target’s accounts into
something like Balance Sheet Valuation form. Recall how an entity’s GAAP accounts are
adjusted in the Balance Sheet Valuation Method:
 The method starts with:
Equity(accrual) = Assets(~cost) – Liabilities a)
 Next, costs of assets are replaced with their market values, and the value of identifiable,
non-GAAP assets is added.
(Examples of non-GAAP assets include patents, brands, and copyrights).
 After these adjustments, equation a) becomes:
Equity(Market Value) = Assets(Market Value) – Liabilities

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

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

Now we are finally ready to define Goodwill. Goodwill is defined as the price paid for the target
in excess of the target’s equity (Market Value). Mathematically:
Goodwill ≡ Price Paid for Target - Equity(target, Market Value)
Conceptually, Goodwill represents the amount paid for the target’s unidentifiable, intangible
assets. These assets may include, for example, the value of the target’s brilliant management
team, the target’s history of reliable, high earnings growth, the firm’s consistent, industry-leading
innovation, etc. (When evaluating firms with Goodwill, many value investors assume this asset
to be worthless and set its value to zero). Goodwill is assumed to be constant forever, unless the
purchased entity loses its economic value to the purchasing company. In this case, the Goodwill
value is marked down.

Other Assets include miscellaneous, economically-valuable stuff that an entity has not listed in
any other asset category. Like Pre-Paid Assets and Notes Receivable, Other Assets may be long
term or short term. (HCP has only long-term Other Assets). An example Other Asset for HCP

CHAPTER 3 – THE BALANCE SHEET PAGE 16

could be an obsolete non-working lawn-care tractor that the company intends to sell as steel
scrap.

In general, Other Assets should comprise a small amount of a company’s total assets. This is
because, without looking at the notes accompanying an entity’s financial statements, we have no
idea what the company’s Other Assets may be. Companies wishing to be transparent and helpful
to readers of its financial statements will aim to make this relatively opaque quantity small.

LIABILITIES
As noted in Why Accounting is so Great chapter, Liabilities are obligations of an entity to make
payments in the future. Liabilities include principal amounts (the amount shown on an invoice
or the amount loaned by a bank), plus any unpaid accruals (such as interest accrued on a bank
loan). Principal amounts and interest accruals for loans, bonds etc. are reported separately.

Liabilities may also be thought of as claims to an entity’s assets. (These claims are not usually
against specific assets, but rather the whole set of an entity’s assets). This understanding of
Liabilities is particularly helpful for firms that liquidate – either by choice or through Chapter 7
bankruptcy proceedings. The claims of liabilities over assets are stronger than claim to assets
held by owners (shareholders), because they arise from invoices or other contractual obligations
to pay. So for example, if HCP decided to liquidate itself (or if it was forced to liquidate in
bankruptcy), it would first sell its assets, and pay off all its liabilities, then pay its shareholders
any leftover funds. (Usually in bankruptcy, an entity’s assets do not bring enough to fully pay off
its liabilities, so shareholders are left with nothing).

Liabilities are also balance sheet items that, if converted to cash today, would require the entity
to pay cash. This is the corollary treatment to assets that we introduced above. As with assets,
we make this consideration in our Barney-like, loving world, usually without consideration of
legal, contractual obligations.

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

CHAPTER 3 – THE BALANCE SHEET PAGE 17

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

Accounts Payable (or AP for short) represents cash owed to suppliers (vendors) for goods or
services furnished but not yet paid for. The Accounts Payable total is typically compiled from
suppliers’ invoices. Credit card purchase liabilities, when expected to be paid promptly, are also
recorded as Accounts Payable. Credit card purchase liabilities that will be paid off over a long
period of time may be classified as Notes Payable. Throughout this text, we treat credit card
purchases as Accounts Payable unless otherwise stated.

When an entity makes a credit card purchase for a non-operating asset, such as PPE, its good to
note this when recording the transaction.4 This will ensure that the entity’s cash flow statements
are correct. For example, say Company X purchases a truck for $10K, paying with a credit card.
Here we should record:
+ Net PPE $10K + AP (Net PPE) $10K

Notes Payable (or Notes) includes cash owed to suppliers (vendors) or others for goods or
services, which is evidenced by formal written notes (ie: short contracts).
As noted above in the discussion of Notes Receivable, Notes typically require repayment of
principal plus interest. As with a Note Receivable asset, a Note Payable liability includes only

4 We will carefully define “non-operating” assets when we discuss Cash Flow Statements. For now its fine to
think of these as assets that will be used to help an entity generate cash for a long time, and not be sold or
converted to cash quickly.

CHAPTER 3 – THE BALANCE SHEET PAGE 18

the principal amount. Unpaid accrued interest will be separately recorded as “Accrued Interest”
and reported as such, or reported in combination with other accruals as “Accrued Liabilities.”
As Notes may be used for many types of transactions, it is good practice to keep separate Note
accounts for operational purchases (such as buying fuel or inventory), plant and equipment
purchases (PPE), and financing transactions (such as borrowing cash from a bank or other
lender). This categorization is very helpful when creating cash flow statements (as we will see
soon), where cash payments are sorted into operating, investing (PPE) and financing sections.
Alternately, Notes Payable may be shown as one entry on the Balance Sheet, and categorized in
the “Notes to the Financial Statements” that should accompany every set of an entity's financial
statements. This is the method being used by HCP.

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

Unearned Revenue (also “Deferred Revenue,” or “Pre-Collected Revenue”) represents services

or goods that an entity has been paid for, but has not yet delivered. An example for HCP might
work as follows:
 On 12/30/20X0, HCP receives $60K from a doctors’ office for Q1-20X1 rent.
Transaction Table entries for this event would be:
+ Cash Asset $60K, + Unearned Revenue Liability $60K
 The $60K is then included in the $10MM of Unearned Revenue that HCP that reported on
its 12/31/20X0 Balance Sheet.

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

At this point you may be wondering (if you are not half asleep) what the future of this liability
will be. Does it stay on HCP’s books forever, or will it be withdrawn? If it's withdrawn, how?
Here is how the future of this liability could play out:
On 3/31/20X1(the end of Q1-20X1), the $60K liability is converted to Revenue (Equity), by this
Transaction Table entry:
- Unearned Revenue (Liability) $60K
+ Revenue (Equity) $60K

After this entry is made, this $60K of Unearned Revenue will no longer appear on HCP’s
Balance Sheet. This amount will be included as “Sales” or “Revenue” in HCP’s Q1-20X1

CHAPTER 3 – THE BALANCE SHEET PAGE 19

income statement because HCP has delivered the good, and included as part of the firm’s Equity
on its 3/31/20X1 Balance Sheet.

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

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

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

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

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

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

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

CHAPTER 3 – THE BALANCE SHEET PAGE 20

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

Owners' Equity is typically reported on Balance Sheets in one of these three ways:
1. A single line (as on HCP’s Balance Sheet), identified as “Equity,” “Owners’ Equity,”
“Shareholders’ Equity,” or “Stockholders’ Equity.”
2. Σ PIC + Σ NI – Σ Div
(As shown on WEA’s Q1 Balance Sheet, and where as usual
Σ NI = Σ {Revenue – Expense}).

3. Σ PIC + “Σ Retained Earnings” (or “Σ RE”), where

Σ RE ≡ Σ NI – Σ Div = Σ {Revenue – Expense} – Σ Div
The meaning of Retained Earnings is:
The total Net Income (NI) earned by an entity over its life, minus the total amount paid to the
company’s owners as dividends.

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

Δ Assets Δ Liabilities Δ Equiy

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

REVENUE AND EXPENSE

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

Revenue is defined to be the sales of goods or services associated with company’s main, day-to-
day business. (IE: Sales resulting from a company’s normal operating business). The most
important aspects of revenue are:
 It is recorded only after services are performed or goods are delivered and ownership passes
to the customer. (For convenience, most examples in this text show recording of revenue
when an invoice for services or goods is delivered. In these cases we assume that the
services have been completed or the customer has taken ownership of the goods when the
invoice is issued).

CHAPTER 3 – THE BALANCE SHEET PAGE 21

 The time of recording is unrelated to when any associated cash is received.
 Revenue does not include infrequent sales of items that are not directly associated with day-
to-day business transactions. So for example, if Apple sells its iPhone assembly plant in
Singapore, the transaction would not be considered Revenue, because Apple is not in the
business of buying and selling smartphone assembly plants.

Expenses are defined as the costs of providing goods or services, which are associated with an
entity’s main, day-to-day business operations. The key things to know about expenses are:
 Unlike revenues, many expenses are recorded as soon as obligations are incurred.
Inventory5-related expenses are an exception, and are booked (recorded) when their
corresponding revenue is recognized. So for example, Apple would record an office-rent
expense every month for its rented headquarters space. It would recognize costs associated
with assembling its iPhones (which are part of the company’s inventory) when the phones
are sold.
 The time of recording an expense is unrelated to when associated cash is disbursed.
 Dividends are not expenses, because they are not associated with the normal, day-to-day
operations of a company
 Infrequently purchased items that are not directly associated with day-to-day business
transactions are also not expenses. Using another Apple example, if the company purchased
an iPhone assembly plant in Vietnam, the purchase price would not be considered an
expense, again because Apple is not in the business of buying and selling smartphone
assembly plants

REVENUE AND EXPENSE EXAMPLES:

1. Which is recorded as Revenue?

a) On 10/01/20XX WEA invoices client $10,000 for valuing their company.
(Hint: in this text we always assume that products or services have already been delivered
before an invoice is issued).
b) On 12/01/20XX WEA receives $10,000 payment from the client.
c) On 12/01/20XX WEA invoices and receives $50,000 for the sale of its headquarters
building.

2. Which is Expense?
a) On 5/01/20X1 WEA’s accountant sends the firm a complete set of 20X0 tax forms and
an invoice for $500.
b) On 7/01/20XX WEA sends the accountant a check for $500.
c) On 12/01/20XX WEA signs a contract to pay $60,000 for its new headquarters building.

5 As noted previously, Inventory is a company’s goods that are being created or waiting to be
sold during its day-to-day course of business.
CHAPTER 3 – THE BALANCE SHEET PAGE 22
Solutions:
1. a). 2. a).

More detailed information on a firm’s Equity is shown on the Owners’ Equity Statement (the OE
Statement), which reports:
ΔE = ΔPIC + ΔNI – ΔDiv6 for one or more accounting periods.
As noted above, the Income Statement (the IS) reports:
ΔNI = ΔRevenue – ΔExpense for one or more accounting periods.
We will cover these statements in the next chapter.

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

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

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

CHAPTER 3 – THE BALANCE SHEET PAGE 23

CHAPTER 3 – THE BALANCE SHEET PAGE 24
RECORDING ACCOUNTING EVENTS

CHAPTER 4
 RECORDING ACCOUNTING EVENTS:
TRANSACTION TABLES
There are three common methods of recording accounting events. We will look in detail
at two of these: Transaction Tables and Journal Entries. The third way to record
economic events, with T accounts, is less helpful than the other methods, and is
particularly ill-suited to the spreadsheet and database applications that are commonly
used in business and finance today.

TRANSACTION TABLE REVIEW

We have already taken a quick look at recording economic events with Transaction
Tables. Below is the Transaction Table for WEA’s first quarter of operations as prepared
in the Accounting Basics chapter:

Note the important properties of the table:

 Duality is preserved for each entry.
 The fundamental accounting equation applies to each entry, as shown in the headings at the
top of the table:
ΔAssets = ΔLiabilities + ΔEquity,
where: ΔEquity = ΔPIC + ΔNI – ΔDiv,
and: ΔNI – ΔRevenue – ΔExpense
 Dollar amounts and accounts are recorded for each transaction.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 2

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

EVENT RECORDING TRIGGERS

The need to record an event (in a Transaction Table or as a set of Journal Entries) is triggered by
two types of accounting events:

1. Economic Event Triggers

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

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

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

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 3

HCP TRANSACTION TABLE EXAMPLE

Let’s create a Transaction Table for HCP’s Q1-20X1 accounting events. (Quantities shown are in
thousands unless otherwise noted):

Here is additional information needed to complete some of the firm’s Transaction Table
entries:
 Beginning of Period Balance Sheet
(BOQ1 20X1, which is the same as EOQ4 20X0)

 HCP’s net PPE “depreciates” (wears out) on average at $40,000K per quarter.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 4

 These accounts, not included on HCP’s BOQ Balance Sheet, will help us record certain
events:

Assets Liabilities Stockholders’ Equity

Pre-paid Expenses Accrued Expenses Revenue
Deferred Revenue Salary expense
Notes (PPE) Write-off expense
Interest expense
Dividends

Below is the completed table, followed by a discussion of how the key transactions were
created. For convenience, the table includes a description of each transaction.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 5

 1. The invoice adds to Accounts Receivable, and allows HCP to declare revenue for
these already-provided services. (As noted in the previous chapter, we assume
that whenever an entity sends an invoice for services or goods, that the associated
services have already been completed or the associated goods have already been
delivered to the customer).
2. Receipt of the oil triggers the creation of the heating oil expense. The invoice received
of $10,000 increases the company’s accounts payable (AP).
3. The new equipment adds to HCP’s PPE, while the obligation to pay for the equipment is
acknowledged in the Notes (PPE) liability. (Again, categorizing the obligation as “Notes
(PPE)” will simplify the work of creating Cash Flow Statements for HCP).

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

4. The electricity purchase reduces cash by $2,000 and generates a pre-paid electric expense
asset. This asset may be reported on Balance Sheets in aggregate with other pre-paid
expenses.
5. HCP’s employees do not invoice the company, so it needs to “note” its unpaid salary
liability whenever it prepares a Balance Sheet. In this case HCP records a $10,000
Accrued Salary liability and recognizes the amount owed as Salary Expense. (Remember
that most expenses are recognized as soon as they appear on an entity’s radar, irrespective
of when they are paid off in cash).
6. Cash from HCP’s customer increases its cash account balance by $1,000. This generates
an Unearned Revenue liability because in Financial Accounting’s Barney-like world, it
would gladly refund these deposits if asked, irrespective of rental agreement legal
wording.
7. Since this piece of HCP’s debt now matures within a year to a year or less, it has to be
moved from long-term debt to short-term debt.
8. The total purchase price of the sheet rock is removed from PPE, because it can no longer
be used to maintain or upgrade the HCP’s buildings. The $500 miscellanies asset is
generated from the estimated salvage value of the resulting wet gypsum board. (The
salvage value is the price HCP thinks it can realize for this soggy mess in the wet-gypsum
marketplace). The net reduction of HCP’s assets reduces the firm’s equity by declaring a
$1,500 write-off or write down expense.
9. As with HCP’s earned-but-unpaid employees’ salary, the company needs to “note” the
amount of accrued-but-unpaid interest on its debt whenever it prepares a balance sheet.
This is recorded in the same way as unpaid salary: HCP notes equal amounts of Accrued
Interest Liability and Interest Expense. The $8,262 amount is computed as:
Total debt at beginning of quarter * 2.533% interest per quarter.
(40,000 + 286,155.0) * 0.02533 = $8,261.5

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 6

 10. Cash is reduced by $4,000, and the accompanying reduction in equity is recorded as a
Dividend.
11. Paying the employees reduces cash by $5,000. Once the employees are paid, HCP no
longer has a related future obligation, so its Accrued Salary liability must be reduced by
the same amount. (Recall again that recognizing the need to pay as an equity-reducing
expense is unrelated to the timing of this cash flow).
12. Paying for a portion of its heating oil reduces HCP’s cash by $5,000. HCP no longer has
a related future obligation to pay this amount, so its Accounts Payable liability must be
reduced by the same amount. (Note that this payment has no effect on HCP’s Heating Oil
Asset).
13. Cash in the door increases the balance of HCP’s cash account by $10,000. Since HCP’s
tenants no longer owe this amount, the company must reduce its Accounts Receivable by
the amount received.
14. The $40,000 of net PPE depreciation (wear) directly reduces net PPE by this amount.
This also represents a reduction in equity, which is acknowledged as Depreciation
Expense.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 7

 WHY CREATE TRANSACTION TABLES?
There are at least three important reasons for creating Transaction Tables:
1. To understand financial implications of a company’s actions
In HCP’s case, our Transaction Table shows, for example, that the company’s debt generates
an interest expense of $8,262K per quarter. This shows that HCP must earn $8.3MM per
quarter to cover its debt obligations before it can put income toward bolstering its economic
sustainability by, for example, expanding or upgrading its facilities.

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

2. To create new financial statements

Both Transaction Tables and journal entries provide firms with data required to
prepare financial statements. If a firm has maintained a history of all its transactions
since inception, nothing else is needed to make a new Balance Sheet, Income, Cash
Flow or Owners’ Equity statement.

3. To understand the changes in an account during an accounting period.

A Transaction Table can be quickly sorted by account. The resulting information provides a
complete history of the activity in each account during the period covered by the Table. This
information is extremely helpful to accountants, CFOs, analysts and auditors who need to
understand how and why various accounts' values changed during the period.

HCP BALANCE SHEET EXAMPLE

Software packages like Quickbooks and AccountingBasicstm create financial statements by
drawing on an entity’s complete database of accounting transactions, as recorded from the
inception of a firm. For learning purposes and for creating models used by investment banks,
private equity firms and investment analysts, it's easier and quicker to create new financial
statements from an entity’s most recent statements, plus all its Transaction Table or journal
entries recorded in its most recent accounting period (whether monthly, quarterly, annually, or
etc). Let’s use the above Transaction Table for HCP and its BOQ1-20X1 Balance Sheet to
create the firm’s EOQ1-20X1 Balance Sheet:

Step 1: Organize the Transaction Table entries by account.

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

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 8

Step 2: Add Beginning of Period balances (BOP balances).
For each account, add the BOP balance (taken from last period’s Balance Sheet) to the total
changes incurred during the period. Include BOP balances for accounts whose values did not
change during the period. This addition produces the since-inception total for each account. As
you can see, this step is consistent with the fundamental accounting equation:

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 9

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

Similarly, the accounts payable for HCP’s balance sheet is:

EOP Q1 accounts payable = $108,000 + $5,000 = $113,000

Step 3: Organize the result in Balance Sheet format.

Here is the completed Balance Sheet:

As shown, Balance Sheet format has several key features:

 The report’s titling includes the fact that it is a balance sheet, the units displayed, and the
period covered. (Balance Sheets are always prepared as of the ending moment of the
period).
 Only account totals are shown, not individual changes incurred during the period.
 Subtotals include (at least) assets, liabilities, equity and liabilities plus equity.
 The fundamental accounting equation is satisfied.
IE: Total Assets(EOP) = Total Liabilities(EOP) + Total Equity(EOP)

Speed Learning Tip:

You should check that you can reproduce this complete Balance Sheet on your own.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 10

HCP ACCOUNT ANALYSIS EXAMPLE
Let's use the above Transaction Table and BOP Balance Sheet to understand how and why HCP's
cash balance changed from $151,862 on 12/31/20X1 (BOP) to $146,862 on 3/31/20X1 (EOP).

We start by reprinting the Assets column of the above Transaction Table, with the events labeled
as well as numbered:

Next we:
 Sort by account.
 Remove all accounts except for Cash
 Add the firm's BOP cash account balance (from its BOP Balance Sheet)
 Compute the EOP cash balance
 Check that the EOP balance matches the balance on the EOP Balance Sheet.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 11

The above table provides everything we need to understand changes to the firm's cash position
during the quarter. We see at a glance that HCP raised $11,000 in cash from payments for
services and acceptance of deposits on future leases. The firm used $16,000 of cash to pay for
electricity, dividends, salaries and heating oil. Also, note that the EOP cash balance computed
here matches the cash balance on HCP's 3/31/20X1 Balance Sheet, as it must.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 12

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

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

The Accounting Period concept says several things:

 Financial statements are to be prepared at regular intervals, covering regular time periods.
IE: a firm may choose to prepare statements on a monthly, quarterly or annual basis, but it
should not prepare monthly statements for January followed by bi-monthly statements
covering February and March.
 An entity’s fiscal year-end does not need to coincide with calendar year-end. Some retail
companies, for example, set their year-end as January 31 to help capture all of its winter
holiday sales and expenses in its fiscal 4th quarter.
 Snapshot reports (IE: Balance Sheets) are prepared as of the end of each period. This is
consistent with the balance sheets we have already reviewed and prepared.
 Flow reports (IE: Income Statements, Owners’ Equity Statements and Cash Flow
Statements) cover one or more periods. So for example, a company that reports quarterly
may provide a quarterly income statement for the first quarter of the year, and an income
statement covering its first two quarters of operations at the end of its second quarter. This
said, most companies that report quarterly also create flow reports that cover just one
quarter.

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

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 13

 RECORDING ACCOUNTING EVENTS:
JOURNAL ENTRIES

OVERVIEW
Journal entries (or journals) are simply lists of accounting transactions generated from events.
For each transaction, a journal entry:
 Records dollar amounts and associated accounts.
 Optionally records “A”, “L”, or “E,” status for assets, liabilities or equity respectively.
(I record this status for all the examples in this text).
 Ensures that duality is preserved.
 Ensures that the fundamental accounting equation is satisfied:
Δ Assets = Δ Liabilities + Δ Equity,
Where as usual, Δ Equity = Δ (PIC + NI + Div), and Δ NI = Δ (Revenue – Expense).

The good news about journal entries is that they are quick to record, and are great for
understanding the implications of an economic event. If we record “A”, “L”, or “E,” status for
each entry, we compile as much information as Transaction Tables produce, albeit in a less
usable form. Unfortunately, it is relatively tedious to create financial statements from journals.

Journal Entries with an Algebraic Sign Convention

Creating journal entries with an algebraic sign convention is relatively straightforward.
Let's see how they work by creating a journal for several of HCP’s Q1-20X1 micro-
economic events:

Here is a journal for the above events:

Q1 Journal – HCP
No. Transaction
1. + $10,000 Accounts Receivable (A)
+ $10,000 Revenue (E)
2. - $10,000 Heating Oil Expense (E)
CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 14
 + $10,000 Accounts Payable (L)
3. + $3,000 net PPE (A)
+ $3,000 Notes (PPE) (L)
4. + $2,000 Prepaid Expenses (A)
- $2,000 Cash (A)

When HCP invoices its tenants, we simply record an addition to Accounts Receivable (AR) of
$10,000 and a matching increase in Revenue of the same amount. By denoting the AR with an
“(A)” and Revenue with an “(E),” we remind ourselves of the classification of these accounts
and make it easy to check that the fundamental accounting equation,
Δ Assets = Δ Liabilities + Δ Equity
is satisfied. The completed journal entry for this event provides as much information as a
Transaction Table entry, in a more compact, list-style form.

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

Journal Entries using the debit (dr) / credit (cr)

Sign Convention
For better or worse, the algebraic sign convention for journal entries is not used as
commonly as the debit (dr) / credit (cr) sign convention. Here’s how the dr / cr sign
convention works:
 Additions to Assets are assigned a dr (debit) “sign.”
Reductions in Assets are assigned a cr (credit) “sign.”
 Additions to Liabilities and Equity are assigned a cr “sign.”
Reductions in Liabilities and Equity are assigned a dr “sign.”

Using mathematical shorthand we can say:

+ Δ(Assets) → dr
and
+ Δ(Liabilities or Equity) → cr.

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

Also note that “debit” (dr) and “credit” (cr) have no special meanings beyond their role in this
sign convention. There is nothing inherently good or bad about debits or credits. The words

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 15

themselves could be replaced with, for example, “quarks” and “muons” without changing their
functionality in accrual accounting.1

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

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

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

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

1 As we will see in the Sources and Uses of Cash and the Indirect Cash Flow Statement chapter of this text,
credits may be thought of as generalized “sources” of cash, and debits may be considered as generalized “uses”
of cash.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 16

EXAMPLE: USING JOURNAL ENTRIES TO UNDERSTAND THE
IMPLICATIONS OF EVENTS
Journal entries help us quickly understand economic events without creating new financial
statements. Let’s consider an example at WEA:

Suppose that, a day after EOQ-1, Partner A buys out Partner B for $6K cash, paying with
a $6K loan taken out by WEA. Let’s analyze the implications for WEA’s Balance Sheet
without creating a new one.

Recall WEA’s EOQ-1 Balance Sheet:

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

1. Take out the loan:

dr Cash (A) $6K
cr Loan payable (L) $6K

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

Note that the net effect of these two events is:

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

With this simplification, the net effects of the buyout on WEA are clear:
 Assets are unchanged (because cash was debited when the firm took out the loan, then
immediately credited when the loan amount was paid to Partner B.)

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 17

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

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

Interestingly, private equity firms don’t often make such a clean swap. In the WEA case for
example, a typical private equity firm might take out a loan for $8K, pay off Partner B for $6K,
and issue the remaining $2K to themselves as a “special dividend.” This is clearly good work if
you can get it.

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

In contrast to sourcing funds via debt, an entity may raise funds from shareholders
(recorded as PIC) with relatively little financial risk. Unlike bank lenders and
bondholders, shareholders give a firm cash in return for nothing except some shares of
stock (representing some percentage of ownership), in the hope that the stock’s value will
rise over time and the company may pay dividends to its shareholders in the future.
Unlike an entity's debt – which contractually requires payments of loan interest and
repayment of principal – a firm's stock comes with legal obligation to pay dividends.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 18

 TIMING OF REVENUE AND EXPENSE
RECOGNITION
One of the most important facets of accrual accounting is the recognition of revenues and
expenses when they appear on the microeconomic radar, irrespective of when associated cash
amounts are received or paid.

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

1. Revenue is recognized before cash is collected.

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

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

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

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

2. Revenue is recognized when cash is collected.

Upon valuing a company for a client at time a), WEA issues an invoice and immediately
receives a $25,000 check for the work. In this case, the journal entries are:
a) dr Cash (A) $25K
cr Revenue (E) $25K

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

3. Revenue is recognized after cash is collected.

Consider this series of events, occurring at times a), b), and c):
a) A customer gives WEA $20K as a deposit for a financial plan to be delivered next
month (sales price $25K).
b) WEA delivers the plan and invoices the client for $5K.
c) The customer pays $5K.

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 19

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

b) dr Accounts Receivable (A) $5K

dr Unearned Revenue (L) $20K
cr Revenue (E) $25K

c) dr Cash (A) $5K

cr Accounts Receivable (A) $5K

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

EXPENSE RECOGNITION
Like revenue, expenses may also be recognized before, when or after cash is dispersed. Let’s
consider each case:

1. Expense incurred before cash is dispersed.

a) On 7/31/2008, WEA is preparing its monthly financial statements, and notes that it has
not paid its $1,000 July office rent.
b) On 8/5/2008, WEA writes rent check for $1,000.

Journal entries for these events are:

a) dr Rent (expense, E) $1K
cr Accounts Payable (L) $1K
b) dr Accounts Payable (L) $1K
cr Cash (A) $1K

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

2. Expense recognized when cash is dispersed.

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

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 20

 In this case, the journal entries are:

a) dr Rent (E) $1K

cr Cash (A) $1K

There is no need for the accounts payable liability, because WEA pays its landlord and
declares the rent expense at the same time.

3. Expense incurred after cash is dispersed.

Consider the following series of events:
a) On 7/31/2008, WEA has already paid (and recorded) July rent, and pays its $1,000
August rent.
b) On 8/30/2008, WEA prepares financial statements for the month of August.

The journal entries for these events are:

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

b) dr Rent (E) $1K

cr Prepaid Expense (A) $1K

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

CHAPTER 4 – RECORDING ACCOUNTING EVENTS PAGE 21

 APPENDIX:
JOURNAL ENTRIES FOR HCP'S Q1-20X1 EVENTS
 CASE STUDY:
THE COLLAPSE OF FANNIE MAE

CHAPTER 5

CHAPTER 5 – THE COLLAPSE OF FANNIE MAE PAGE 1

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

Traditionally, FNM made money as follows. It would:

 Raise (say) $100BB in cash from bank loans and bond issuance. As a GSE supposedly
doing safe business for the public good, FNM would get a great interest rate on these
borrowings – lets say 3% per year.
 Use this cash to buy $100BB in mortgages from “mortgage originators” and “mortgage
aggregators.” (Originators are the folks who actually offer homebuyers a mortgage loan.
Aggregators purchase mortgages from originators, usually with the intent to sell them in
large blocks to firms like FNM). The average interest rate paid by the mortgage borrowers
(homeowners) would be about 6% per year, while FNM was borrowing at 3%.
 Enjoy receiving about twice as much interest from the mortgages it purchased than the
interest it had to pay to its borrowers. FNM would receive a bit less than 6% from the
mortgages it purchased (say 5.9%) because some mortgage borrowers would make late
payments or default on their loans. So per year, FNM might make $2.9BB from the $100BB
of its mortgages, computed as follows:
$100BB * (0.059 – 0.030) = $2.9BB/yr

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

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

CHAPTER 5 – THE COLLAPSE OF FANNIE MAE PAGE 2

To get from FNM's “Accrual Accounting” (As-Reported) 6/30/08 Balance Sheet to the “True
Value” Balance Sheet, the company's mortgage assets would be simply written down by 10%, as
shown in the “Minus BS” column. IE:
cr Mortgages $77,414,500
dr Mortgage write down expense $77,414,500
The effect of the write-down, as seen in the “True Market Value” Balance Sheet, is to reduce
FNM's 'true-value' equity to -$36,188,500. If the analyst's assessment was correct, the true value
of FNM's assets was less than the definate value of its liabilities by this amount. As most of
FNM's liabilities were loans and bonds, this implied that FNM would be unable to repay its loan
and bond obligations.
As lenders started to believe that analyses like the one above represented FNM's actual situation,
they stopped taking on new debt from FNM, and tried to sell the FNM loans and bonds they
owned.
At this time in 2008, FNM either owned or guaranteed about 40% of all the mortgages in the
U.S. Because of this extraordinary involvement in the mortgage market, decision makers in the
federal government came to believe that if FNM collapsed, the turmoil in the mortgage market
would be huge, and might help propel the country into a very deep recession or depression.

CHAPTER 5 – THE COLLAPSE OF FANNIE MAE PAGE 3

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

The details of this government bailout were as follows:

 The government would immediately give FNM a large amount of cash (say $40,000MM),
making the firm's equity worth more than zero.
 In return, the government would receive “preferred stock” in FNM, with these features. The
preferred shares would:
 Have a higher claim on FNM’s assets than the claims of existing “common equity”
shareholders.
 Have no voting rights. (The lack of voting rights would help fight off allegations that
the bailout was really a socialist takeover of the firm).
 Include a mandatory dividend.
 Require that all outstanding preferred dividends be paid and all preferred shares be
repurchased by FNM before the entity could issue dividends to common shareholders or
repurchase its common stock shares.
 The government pledged to put in as much additional cash as necessary to ensure the
continued operation of FNM. The government would receive additional preferred stock
with each new cash injection.
Here is a set of Balance Sheets and journal entries for an initial $40MM cash infusion:

CHAPTER 5 – THE COLLAPSE OF FANNIE MAE PAGE 4

The cash injection restored FNM to a positive equity position (of $3,822,500K), and changed its
equity structure. The journal entries for the infusion are:
dr Cash (A) $40,000,000K
cr PIC (preferred equity) (E) $40,000,000K
As a result of the government's cash infusion and its stated commitment to financially support
FNM in the future, lenders began to believe that any cash lent to FNM would be repaid, with
appropriate interest. As a result, some of them resumed doing business with the firm. More
importantly, a possible depression-precipitating collapse of FNM's operations was averted. In
fact, FNM did so well after the bailout that by September 2009 it either owned or guaranteed
70% (!) of all residential American mortgages.
Although FNM's lenders, mortgage market participants and the U.S. economy benefited from the
bailout, the firm's existing shareholders were not as fortunate. As noted above, the government's
preferred-shares specified that FNM pay all outstanding preferred dividends and repurchase all
the preferred shares before the firm could issue dividends to its common shareholders or
repurchase its common stock shares. These stipulations effectively made the value of FNM's
common stock almost worthless.

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

CHAPTER 5 – THE COLLAPSE OF FANNIE MAE PAGE 5

CHAPTER 5 – THE COLLAPSE OF FANNIE MAE PAGE 6
 INCOME, OWNERS’ EQUITY
AND CASH FLOW STATEMENTS

CHAPTER 6

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 1

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

The Conservatism Concept says three things: Accounting Concepts

a) When appropriate, reduce the value of 1. Accrual.
assets from cost (or cost minus wear) to 2. Money measurement.
market value. Recall that this is how we 3. Duality.
treated HCP’s destroyed sheet rock. 4. Entity.
5. Going concern.
b) Recognize only revenues and additions to
6. Cost.
equity that are reasonably certain. (IE:
7. Accounting period.
collection is calculable, assured by a
8. Conservatism.
purchase order or written agreement, and
9. Realization.
expected from a customer with little
10. Matching.
bankruptcy risk).
11. Consistency.
c) Recognize all expenses and liabilities that 12. Materiality.
are reasonably possible and estimable. (IE:
an expense or liability that is more likely to
be incurred than not, with at least an
approximately estimated dollar value).

Important things to note about the first statement include:

 Determining when its “appropriate” to mark down the value of an asset is non-trivial, and
sometimes the source of disagreement between a company and its auditors or potential
investors.
 The value of an asset is generally not “written up.” Exceptions include assets that were
mistakenly recorded at the wrong value and assets that are always “marked to market,” such
as cash invested in money market funds or another entity's publicly traded stock.

Examples:
What should the items listed in a) and b) be valued at?
a) Dole's farmland in Hawaii, purchased in 1939 for $1,000 per acre but worth about
$10,000/acre today.
b) Centex's homes for sale in South-Florida. Centex is a publicly-traded homebuilding
company, with ticker symbol CTX). In 20X0, the company built 100 South-Florida homes at a
cost of $400,000 each. In 20X1, Centex sold only 5 of the homes, at about $300,000 each.

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

c) WEA’s Assets Under Management fee for its Protect and Grow – HY investment product is
1.0% per year. Because 20X0 was a bad year, WEA invoiced just $5,000 to a client with $1MM
under management.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 2

Solutions:
a) $1,000 per acre. This example reminds us that accrual accounting value does not necessarily
represent economic value.
b) $300,000 each. The market is clearly telling CTX that its homes are worth $300,000,
irrespective of the company's cost to build these structures.
c) $5,000. Regardless of what WEA was contractually able to bill, accrual accounting only
records what was actually invoices.

The Realization Concept says to recognize revenue when products or services are delivered (and
not before). Delivery of tangible goods means that ownership passes to the customer. (In this
text, we assume for convenience that services have been completed or goods have been delivered
before an invoice is issued. This allows us to use invoicing as a trigger for declaring revenue).

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 3

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

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

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

Statement of Owners’ Equity:

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

Statement of Cash Flows:

 Reports the flow of cash only over a period of time.
 Sorts these movements into operating, investing, and financing buckets.
 Like the Income and Owner’s Equity statements, it’s also a flow report, making the Balance
Sheet our only snapshot or level report.

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

The most basic form of an Income Statement is:

ΔRevenues – ΔExpenses = ΔNet Income (ΔNI), or
Revenues (in the period) – Expenses (in the period) = Net Income (for the period).

By convention, revenues are usually grouped into one or several items, such as simply
“Revenue,” or “Consulting Revenue” and Product Sales Revenue.” Expenses, by contrast, are
usually listed by individual account. As we have seen with Balance Sheets, similar expense

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 4

accounts are often aggregated on Income Statements. So for example, electric power and water
expenses may be reported together as “Utility Expenses.”

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

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

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

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

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

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 5

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

Income Statement For period: Q1 2002

West End Advisors, LLC $USD UON1
Revenue $8,000
Salary Expense $3,000
Rent Expense $1,000
Net Income $4,000

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

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

INCOME STATEMENT FOR HCP

Now let's create an Income Statement for HCP's Q1 of 20X1, which will be more realistic and
complicated than WEA's Q1 Statement. Recall HCP’s Q1-20X1 economic events:

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 6

Here is a list of journal entries for these events:

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 7

Speed Learning Tip:
For practice, re-create the above list of journal entries from the associated economic events.

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

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 8

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

Income Statement For period: Q1 20X1

Health Care Properties (HCP) ($000 UON)
Revenue $10,000
Expenses:
Salary $10,000
Depreciation $40,000
Heating Oil $10,000
PPE write off $1,500
Interest $8,262
Net Income (loss) ($59,762)

Here again we've used the Income Statement convention that expenses carry a positive sign.
Also like WEA, HCP does not pay income tax and therefore has no tax expense. REITs like
HCP are able to avoid paying income tax if they distribute at least 90% of their taxable income
(similar to income before tax)2 to their owners as dividends. LLCs and their cousins, S-
Corporations, pay no income tax irrespective of their net income “payouts” to their owners.

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

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

2 “Taxable Income” is computed on entities’ tax returns, which in simple cases are similar to their Income
Statements. In a later chapter, we take on taxation of entities in more detail.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 9

1. In Q1, expenses outran revenues by $59.8MM
2. The firm's salary expense was equal to 100% of its revenues, leaving nothing to meet
other expenses.
3. HCP's interest expense totaled 83% of revenues for the quarter.
4. Depreciation expense was very high, coming in at 4 times sales.
5. PPE had to be written off.

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

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

Here are some other important questions that the Income Statement raises but leaves
unanswered:
1. Was this quarter's operations an anomaly, or part of an inexorable slide into financial
oblivion?
2. If the quarter's poor operating performance was anomalous, was problem caused by a drop
in sales or an increase in expenses?
3. How did HCP’s performance compare to its competitors in the quarter?
4. How much of HCP's expenses were paid in cash? And how much cash and borrowing
capacity does the firm have in reserve?

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

§ Historical Income Statements.
These would answer whether or not this quarter's performance was anomalous.
§ Income Statements (ISs) of comparable companies (often called “comps”).
Comp's ISs would tell us how HCP's financial performance relates to other entities in its
industry.
§ “Notes to Financial Statements.” These notes are considered to be part of any set of
financial statements, although in this text we will usually omit them.
HCP's Notes should explain the reason for its PPE writeoff.
§ Other financial statements.
HCP's Cash Flow Statement, for example, would show how much of HCP's expenses
were paid in cash during the quarter.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 10

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

EBIT aims to show an entity's earnings generated by its day-to-day business operations, without
consideration of its financing obligations or tax status. It is used, for example, to evaluate
regional managers, who have no control over the company's tax rate, or corporate-level decisions
to take out or pay down loans. These facts make EBIT a more appropriate performance-
evaluation tool for managers than Net Income (NI).

A quick review of HCP's Income Statement shows that its Q1-20X1 EBIT was -$46,500K. Here
is the firm's complete IS with EBIT subtotaled:

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 11

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

The OES shows detailed changes to the PIC and DIV portions of equity, but Income-Statement-
related changes are summarized only by a single Net Income entry. (Alternately, Net Income and
Dividends may be combined into “Retained Earnings” on the OES).

OESs' show more within-account detail than the other three financial statements. For example, if
an entity issues stock to its employees and also to new owners in a given period, it will show
both issuances on its Owners Equity Statement, instead of reporting the total issuance as one PIC
entry. This is illustrated in the example Owners' Equity Statement below.

OESs are flow reports, and satisfy this “roll forward” or “flow” equation:
EquityBOP + ΔNI + ΔPIC - ΔDIV = EquityEOP
They may be organized in a spreadsheet-like format as show below, with equity accounts listed
as columns, and individual rows for specific types of changes to equity.

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

OWNERS’ EQUITY STATEMENT EXAMPLE

Let's create an Owners' Equity Statement for WEA's first quarter of operations, using the
company's Q1 journal entries shown below. Note that WEA's buyout of Partner 2 has been put
into Q1 for this exercise.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 12

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 13

The highlighted Income Statement items (shown with an orange background) will be aggregated
into Net Income = $4,000.

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 14

Notes on the Statement:
1. The entity name and accounting period are as-always included at the top of the report.
2. WEA's BOP balances are zero because the firm started operations in this period. In
subsequent periods the BOP balances could be pulled from the prior period's OES.
3. The row and column totals are both equal to $6,000, as shown in the lower-right entry of the
table. This entry also matches the EOP equity reported on WEA's Q1 Balance Sheet.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 15

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

Firms may measure ownership in one of two ways:

1. By keeping track of what percentage of the firm is claimed by each owner. This is called
percentage ownership. An example PIC transaction would be “Partner 1 gave $5K to the firm
for a 50% ownership stake” (see journal entry of 6/18/2002 in table above).
2. By issuing shares of stock, each of which indirectly represents a fixed percentage ownership
of the firm. This is called share ownership. An example would be “Mr. HotInvestor purchased
1,000 shares of the company for $20,000 (or for $20 per share). At the time, the firm had 10,000
shares outstanding.” Here we compute HotInvestor's percentage ownership as 10% =
1,000/10,000.3

LLCs may choose to measure ownership by either method. C-Corporations, which include
almost all publicly traded companies, must use the share ownership method.

Here are some good-to-know, commonly-used share ownership terms:

 Shares authorized. The number of shares a company may legally issue, as defined in its
charter. (In most circumstances companies may choose the number of shares authorized
themselves, and they usually pick a very large number).
 Shares issued. Shares that have been issued by the company to owners for the first time.
(Some of these shares may have been subsequently repurchased by the entity).
 Treasury shares. Shares that have been issued and subsequently repurchased by the firm.
 Shares outstanding. Shares issued minus Treasury shares. The market value of an entity's
equity is equal to Shares outstanding * Price per share. Note that Treasury shares and
authorized-but-unissued shares do not count toward the market value of the firm. (IE: they
are assumed to have a value of $0.00 per share).

3 Although we will consistently use this straightforward method of accounting for share issuance, GAAP specifies
a slightly more complex method in some circumstances. Here are some of the gory details. (More complete
information is available in good technical manuals for GAAP-Accounting, such as the Miller GAAP Guide and
the CCH GAAP Guide).

When a company is established, it may specify the “par value” of its stock in its charter. Par value is usually
defined as the lowest price per share that the company may issue stock at. Companies usually choose a very
small number for par value, such as $0.001 per share or less.

Lets say the company above established the par value of its stock at $0.001 per share. In this case, its sale of
1,000 shares to Mr. HotInvestor for $20/share would be recorded as:
dr Cash $20,000.00
cr PIC at par value $1.00 = $0.001 * 1,000
cr Additional PIC $19,000.00 = $20,000 - $1

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 16

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

While we are on the subject of ownership transfers, this is a good time to reinforce the
implications of +PIC and -PIC transactions. +PIC transactions (positive PIC transactions)
represent an entity's receiving cash or other assets in return for awarding someone or some entity
an ownership stake, as measured by % ownership or a certain number of shares. The entity's
equity of course increases through such an event.

Similarly, -PIC transactions (negative PIC transactions) represent an entity's paying cash to
owners in return for the relinquishment of their ownership stake. These transactions are called
“share repurchases,” “buybacks” or “buyouts”. Owners participating in buybacks reduce their
ownership stake in an entity by either surrendering their % ownership (in Percentage Ownership
situations) or by surrendering their shares (in Share Ownership situations).

Repurchased shares are called Treasury shares as defined above. As previously noted, Treasury
shares, like authorized-but-unissued shares, are assumed to have a value of $0.00 per share.
Therefore, a firm's equity is always reduced when it repurchases shares of its stock.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 17

 CASH FLOW STATEMENT (CFS)
As we know, the Cash Flow Statement (CFS) reports all of an entity's cash flows over an
accounting period or periods. Cash flow reports include physical bills and cash held in any
“demand deposit” account, from which cash can be withdrawn at any time without incurring a
penalty or risk of principal loss. Such accounts include checking balances and money market
funds, but not certificates of deposit (CDs) or short-term Treasury notes.4

CFSs satisfy the roll-forward or flow equation:

CashBOP + ΔCash = CashEOP
BOP and EOP balances must, as usual, match their corresponding Balance Sheet entries.

The three cash flow categories are detailed as follows:

1. Cash Flows from Operations (Operating Cash Flows, OCF)

The Operating section of the CFS includes all Income Statement-related flows. This
includes, for example:
i) Any cash flowing in or out from the day-to-day production and sale of products or
services, such as:
§ Paying for inventory
§ Receiving cash from product or service sales
§ Paying suppliers and employees' salaries
ii) Other Income-Statement-related flows, such as:
§ Paying or receiving loan interest
§ Paying income taxes

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

2. Cash flows from Investing (Investing Cash Flows)

Investing Cash Flows include any non-operating cash flow to or from a 3rd party, which is
associated with the investment of a firm’s resources. Examples include:
§ Purchase or sale of Property, Plant and Equipment (PPE)
These transactions are called “net Capital Expenditures” or “net CAPX”.
4 CD's are excluded because they have an early-redemption penalty feature, and Treasury notes are excluded
because their principal may only be redeemed on their maturity date.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 18

 § The purchase or sale of another firm’s stock or bonds.
§ Make loans or receiving loan principal repayments.
Note that these transactions would be operating flows for firms in the business of
making these kinds of deals. For example, cash expended for the purchase of a building
would be an operating flow for a firm in the business of buying and selling properties.

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

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

Financing Cash Flows are any non-operating cash moving to or from a firm’s stakeholders.
Stakeholders include a firm's owners (shareholders) and lenders (banks, bondholders, etc).
Example financing transactions include:
§ Taking out a loan and repaying its principal.
§ Issuing bonds and repaying the principal.
§ Issuing or repurchasing stock (+PIC and -PIC transactions, respectively).
§ Distributing dividends to shareholders.

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 19

 METHODS FOR CREATING
CASH FLOW STATEMENTS
There are two ways to create a cash flow statement – the “Direct Method,” and the “Indirect
Method.” Direct Method Cash Flow Statements are developed by:5
a) Organizing all cash journal entries (or transaction table entries) into Operating, Investing
and Financing groups.
b) Showing BOP and EOP cash balances at the top and bottom of the report. (The BOP
balance may be found on the prior period's Cash Flow Statement or Balance Sheet).
c) Checking that the EOP cash balance computed from the statement being created matches the
corresponding balance sheet number). IE: Checking that CashBOP + ΔCash = Cash EOP.

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

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

DIRECT METHOD CASH FLOW STATEMENT EXAMPLE: WEA Q1

Let's assemble a direct method Cash Flow Statement for WEA's Q1, using the firm's Q1 journal
entries and the fact that its BOPQ1 cash balance was zero. Once again, the firm's buyout of
Partner 2 is included in the quarter to increase the quarter's excitement.

5 Direct Method statements may also be constructed by inspecting changes in all accounts except the Cash
account. In this case, each account is searched for changes whose “other side” entry is ΔCash. This technique
is sometimes used by entities that record a very large number of vaguely labeled cash transactions.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 20

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 21

Note that only half of the Revenue claimed in the period was paid in cash (IE: $4,000).

Our second step is to sort the cash entries into operating, investing and financing groups, while
recording the reason for each cash change. The reason for a change in cash is given by the
appropriate non-cash section of the cash-containing journal entry.

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 22

Here are some good things to note about the completed statement that apply to all CFSs:
1. As with all financial statements, CFSs must be titled, indicate the name of the entity
concerned, the accounting period covered, and units (if not US dollars).
2. BOP and EOP cash levels are indicated, and must match their corresponding balance sheet
entries.
3. The report carries an algebraic sign convention, with inflows carrying positive signs and
outflows holding negative signs. (Recall the Income Statement is the only financial report
with a non-algebraic sign convention).
4. Like all reports except the Statement of Owners Equity, CFSs show account subtotals
instead of within-account detail.

What WEA's CFS Does and Does Not Say:

A quick review of WEA's Q1 CFS reveals some notable points and suggests the need to analyze
CFSs in concert with other financial reports:
1. No net cash came in from operations. Is this a bad thing?
The answer here is 'not necessarily.' Usually businesses expend cash upfront to help them
provide a service or deliver a product, and get paid at a later time. The Revenue line of the
IS would help us here, by showing how much cash was earned, irrespective of whether or
not the associated cash had been received at the end of Q1.

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 23

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 24

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

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

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

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

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 25

CHAPTER 6 – INCOME, OWNERS’ EQUITY AND CASH FLOW STATEMENTS PAGE 26
ENTITY TYPOLOGY, INVENTORY AND
COST OF GOODS SOLD (COGS)

CHAPTER 7
 ENTITY TYPOLOGY
For accounting purposes, entities may be classified by the products and/or services they provide.
For example, Tesla Motors (stock symbol TSLA) primarily sells tangible goods – luxury electric-
powered cars – and may accordingly be called called an “industrial” company. By contrast,
WEA and HCP provide services – asset management and the right to inhabit a space respectively
– making them “service” or “consulting” entities.

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

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

Revenue earned
primarily from: Entity type: Examples:

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

2. Fee for a service. Service Architects, WEA, HCP,
(Consulting) M&A advisers with no banking affiliation.
3. Investment interest, Financial Banks, payday lenders.
dividends or capital
gains.

4. Selling goods and Combination Apple

services. Tangible: iphones, ipads, Macs.
Service: music subscriptions, etc.
Banks that also offer M&A advisory services
or financial planning services.

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 2

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

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

These events are treated by GAAP Accounting as follows:

A) When FastBikes purchases a motorcycle.
 The purchased motorcycle is an asset, called “Inventory.”
 The cost of the bike is recorded in the firm's Cash or Accounts Payable account.
 No expense is incurred.
This treatment is similar to the recording of PPE purchases that we have seen for Service
companies.

B) When the firm sells a motorcycle:

 Revenue is recorded, at the sale price of the bike.
 Cash or Accounts Receivable is increased by the same amount.
 The Inventory asset account is reduced by the cost of the motorcycle (in recognition that the
firm no longer owns this asset).
 The firm records a “Cost of Goods Sold” Expense (“COGS” Expense), equal to the amount
of the Inventory reduction (IE: equal to the cost of the bike).
The first two items follow the recording of revenue for service firms. The last two items are
unique to the day-to-day sale of tangible goods.

INVENTORY IN-DEPTH
Accrual accounting formally defines Inventory as these two types of things:
1. Tangible items that are held for sale in the ordinary course of business, or items that are in
the process of production for normal-business sales.
2. Labor and other costs that are directly required to fabricate or assemble completed, ready-
for-sale products.

Other important characteristics of Inventory are that:

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

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 3

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

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

Solution
a) Yes. The firm's day-to-day business is the manufacture and sale of tractors and other heavy
equipment.
b) No. Farms are primarily in the business of growing and selling crops and livestock, not
tractors. A tractor is PPE for a farm, as it will be used to help generate sales over a long period.

ANOTHER EXAMPLE:

Consider Centex Corporation (CTX), which is

in the business of producing and selling single-
family homes. (Firms like this are called
“homebuilders” on Wall Street).

Which of the following is inventory for CTX?

a) Land that CTX plans to develop in 5 years.
b) Homes – completed and in construction.
c) Labor costs that are directly associated with home construction.
d) The electric bill for house under construction.

Solution
a) No. This is not a current asset. (Note that the answer to this question depends on CTX's
intent).
b) Yes.
c) Yes.

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 4

d) Yes. (You could argue for “No” if you believe that all homes should be constructed Amish-
style, with no power tools or electric lighting).

RELATIONSHIPS BETWEEN INVENTORY, COGS,

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

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

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

dr $xxx Cash or AR (typically) (A)

cr $xxx Revenue (E)

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

dr $yyy COGS Expense (E) ; recognize the expense

cr $yyy Inventory (A) ; remove the asset

Over any given accounting period, Inventory and COGS are related by this “roll forward”
equation:
InventoryEOP = InventoryBOP + Purchases – COGS – Write Downs

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

INVENTORY, COGS, AND REVENUE EXAMPLE

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

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 5

2011 Jetta TDI (Diesel)

GCC's conversion challenges are centered

around the viscous properties of bio-fuels. Most
bio-diesel has about the same energy density as
its petro-chemical based cousin, but it is more
viscous, especially at low temperatures as
shown in the adjacent graph. (Viscosity
measures resistance to flow. Honey and
molasses, for example, are relatively viscous
fluids, while water has a relatively low
viscosity).
To accommodate the high viscosity of bio-fuels,
GCC modifies fuel systems by increasing the
diameter of fuel injectors, and installing heating elements along fuel lines.

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

1. GCC buys a car to refurbish for $15K, and gets invoiced.

2. GCC sells the car to a Jetta fanatic for $20K before it has time to do any reconditioning, and
invoices this customer.

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

1. dr Inventory $15,000. (A)

cr AP $15,000. (L)

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 6

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

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

Income Statement (IS) for the period:

Revenue $20K
COGS Expense $15K
Net Income $5K

ΔBalance Sheet (ΔBS) at EOP:

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

Assets:
Accounts Rec. $20K

Liabilities:
Accounts Payable $15K

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

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

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

ACCOUNTING CONCEPTS, CONTINUED

Recall our accrual accounting concepts:
1. Accrual,

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 7

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

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

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

The implications of this concept for inventory are:

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

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

For Entity Type Recognize Revenue When

CTX Industrial House title is transferred.
GCC Industrial Car is delivered.
WEA Consulting When invoice delivered.

Now lets add the Matching Concept to our repertoire. The Matching Concept is similar to the
Realization Concept, except it establishes when to record expenses, instead of revenues. It says
specifically:
a) Inventory costs associated with the revenues of a given period are “expensed” (recorded as
expenses) when that revenue is declared. The associated recording methodology is:
 First determine the revenues.
 Then expense the matching inventory costs.
b) The cost of long-lived assets like PPE, patents or mineral deposits should be expensed over
their useful lives. IE: the costs are matched to the periods in which they provide an
economic benefit. For example, a new truck with a 10 yr life and no salvage value will
generate a depreciation expense equal to 1/10th of its cost, for the next 10 years.
Reminder:
As we have seen before, matching expenses for PPE, patents and mineral deposits are called,
respectively, depreciation, amortization and depletion.

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 8

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

ANOTHER INVENTORY, COGS AND REVENUE EXAMPLE

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

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

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

The Journal Entries for these events are:

1. dr Inventory (A) $15,000
cr AP (L) $15,000
2. dr Inventory (A) $1,000
cr Cash (A) $1,000
3. dr Inventory (A) $800
cr Accrued salary (inventory) (L) $800
4. dr Inventory (A) $100
cr Accrued rent and electric (inventory) (L) $100
5. Hint: Recognize the revenue, match the expense.
dr AR (A) $25,000
cr Revenue (E) $25,000
dr COGS Expense (E) $16,900
cr Inventory (A) $16,900

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

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

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 9

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

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

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

Asset Account Entries Liability Account Entries

cr Cash $1,000 cr AP $15,000
dr Accts. Rec. $25,000 cr Accrued rent/elec. $100
dr Inventory $15,000 cr Accrued salary $800
dr Inventory $1,000
dr Inventory $800 Owners Equity (IS) Entries
dr Inventory $100 cr Revenue $25,000
cr Inventory $16,900 dr COGS Expense $16,900

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

ΔBalance Sheet

Assets Liabilities
Cash ($1.0K) Accounts Payable $15.0K
Inventory $16.9K Accrued Expenses $0.9K
Total Assets $15.9K Total $15.9K

Owners Equity $0.0K

Liabilities + Equity $15.9K

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 10

Income Statement
Revenue $0.0K
Expense $0.0K
Net Income $0.0K

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

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

ΔBalance Sheet

Assets Liabilities
Cash ($1.0K) Accounts Payable $15.0K
Accounts Receivable $25.0K Accrued Expenses $0.9K
Inventory $0.0K Total $15.9K
Total Assets $24.0K
Owners Equity $8.1K
Liabilities + Equity $24.0K

Income Statement
Revenue $25.0K
COGS Expense $16.9K
Net Income $8.1K

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

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

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 11

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

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

As the entries imply:

 Since the heaters are useless as inventory, their full cost most be removed from this account.
 GCC gets a new asset out of this mess: $500 worth of stuff to sell to a scrapper. Since this
sort of asset should not appear often, its fair to label this it as a “Miscellaneous Asset.”
 The net amount of the inventory write down is a reduction to the firm's equity. The equity is
reduced by declaring this amount as “Inventory Write Off Expense.” It is virtually always
the case that the net amount of a write-down (of Inventory, PPE or any other asset) reduces
equity through a Write Down Expense.

Some general implications of an inventory write off are:

 Inventory must always be “written down” to its current value whenever the value falls below
cost.
Inventory is accordingly said to be “carried at lower of cost or market value”.
 The equity-reducing expense associated with an inventory write off may be recognized as
either “Inventory Write Off” expense or “COGS” expense. Accounting experts suggest
(properly) that large write offs should be recognized as the former. Their reasoning is that
using “Inventory Write Off” provides readers of firms' Income-Statements with more and
better information. If “COGS” is used, an outside-the-firm reader would not know that a
write-down occurred.
 A write down is recorded as soon as the inventory's value (or the value of any other asset for
that matter) falls, irrespective of any revenue recognition. If the write down is handled with
a COGS Expense, this is an exception to COGS matching revenue.

Here is a simple Inventory Write Down example, where it is appropriate to reduce equity using
COGS Expense:
Consider a banana importer who owns a load of bananas costing $2,000K. The bananas are in
the hold of a ship in NY Harbor, and they have not been unloaded due to a conflict with the local
teamsters union.

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 12

 As Marlon Brando pointed out in the classic
film On the Waterfront, “Them bananas go bad
in a hurry.”

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

Here are write-down journal entries for the unfortunate importer:

cr Inventory (A) $400K
dr COGS (E) $400K

A NOTE ON THE REAL-WORLD TREATMENT OF

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

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

Journal Entries
1. dr Inventory (A) $15,000.
cr AP (L) $15,000.
2a. Recognize the revenue and payment owed at the time of the sale:
dr AR (A) $20,000.
cr Revenue (E) $20,000.
2b. Reduce inventory and match the expense when compiling the firm's next set of financial
statements:
dr COGS Expense (L) $15,000.
cr Inventory (A) $15,000.

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 13

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

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

Purchase date Gallons Price/Gallon

1/1/20X1 500 $4.00
2/1/20X1 300 $3.00
3/1/20X1 200 $2.00
So the average cost to fill the tank is $3.30 per gallon

The firm may then sell 200 gallons on 3/31/20X1 for $1,000 or $5.00 per gallon. In this case,
the firm has three choices for establishing the associated COGS Expense for the period 1/1
through 3/31:
1. Using the Average Cost Method, the firm would record COGS Expense as $3.30/gallon *
200 gallons = $660.
2. Using the First-In, First-Out Method (the FIFO Method) the firm would record COGS
Expense as $4.00/gallon * 200 gallons = $800. Here the firm uses the price of its first
inventory purchase to compute COGS, and would continue to use this price ($4.00 per
gallon) until it has sold 500 gallons.
3. If the firm chooses the Last-In, First-Out Method (the LIFO Method), it would record COGS
Expense as $2.00/gallon * 200 gallons = $400. Here the firm would be using the price of its
most recent inventory purchase to compute COGS. COGS Expense for its next sale would
be at $3.00 per gallon (or some combination of $3.00 and $4.00 per gallon for a large sale),
because the all the fuel it purchased for $2.00 per gallon would be gone.

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

CHAPTER 7 – ENTITY TYPOLOGY, INVENTORY AND COST OF GOODS SOLD PAGE 14

SGA, DEPRECIATION REVISITED,
AND TAXES

CHAPTER 8
 SELLING, GENERAL,
AND ADMINISTRATIVE EXPENSE (SGA)
Selling, General and Administrative Expenses (SGA) are defined to be expenses associated
with the routine production of goods and services that are not:
 COGS, Interest, Depreciation, Write-Downs, Other Income (Expense) or Tax.
 Additional separately-reported expenses.

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

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

As with virtually all expenses except for the inventory-related COGS account, SGA expenses are
not “matched” to revenue. IE: They are incurred as as soon as reasonably probable, per the
Matching and Conservatism concepts.

SGA EXAMPLE FOR GCC:

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

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

Find the journal entries for the day's events, and an Income Statement for the period (assuming
nothing else happened in the period and remembering that GCC is an LLC).

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

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 2

2. dr Marketing (Sales) Expense $500 (E)
cr Accounts Payable $500 (L)
3. dr Inventory $400 (A)
cr Accrued Salary (Inventory) $400 (L)

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

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

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

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 3

 DEPRECIATION REVISITED
Recall that depreciation is thought of as:
 The process of expensing the cost of a long-lived asset – such as PPE – over the asset’s
“useful life”, and
 The the process of reducing the book value of a long-lived asset as its “useful life”
decreases. Here “useful life” is established by FASB or a firm's accounting policies, and
may not be the same thing as the actual life of the asset.

Let's review how we have treated depreciation

until now, through looking at the life of a CNC
mill used by GCC to modify cars' fuel injectors.

The important accounting aspects of this mill

are:
GCC purchased it on 12/31/20X0.
 It cost $50,000. (This is the mill's “initial
book value”).
 GCC expects the mill to have a 5 yr useful
life and no “salvage value.” (IE: the mill
will have no resale value at the end of its
useful life).
 GCC uses “straight line” (linear)
depreciation. This means that the company
expenses a constant % of its assets' cost per
year. For this mill, GCC will expense one
fifth (20%) of its cost per year.

We’ve previously learned to account for mill asset and its aging as shown in these journal
entries:
12/31/20X0: Buy the mill, paying with cash
cr Cash $50,000 (A)
dr Net Mill Asset $50,000 (A)
(Where “Net Mill Asset” is a subset of “Net PPE”)

12/31/08: Reduce book value of mill by 20%, and incur an expense for 20% of the mill's
value:
dr Depreciation Expense $10,000 (E)
cr Net Mill Asset $10,000 (A)

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 4

Although this method is often used in finance1 and yields correct financial statements, it is not
exactly what GAAP requires. The GAAP method of handling the mill and its depreciation
are slightly more complicated.

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

'You couldn't have

handled the truth!'

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

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

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

To enable this reporting, we record economic events for depreciable assets like this:
1. When a depreciable item is purchased, establish:
a) An asset account for the cost of the item. This account value will stay constant for the
life of the asset. So when GCC buys a mill we will establish a “Mill Asset” account,
instead of a varying-value “net Mill Asset” account.
b) An “Accumulated Depreciation” account (AD), to show the wear or reduction in value
of the asset. AD accounts are called “contra asset” accounts, and work like this:
 They are associated with a specific asset or group of assets (such as a specific mill
Asset or all of a firm's PPE).

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

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 5

  In dr/cr parlance, an addition to a contra asset account is designated with “cr.”
 When shown on a balance sheet, these accounts appear directly below the asset
they are associated with. In this sense they are like a pilot fish is to a shark.

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

12/31/20X0 events and journal entries:

GCC buys the mill, paying with cash.
dr Mill Asset (a subset of PPE) $50,000 (A)
cr Cash $50,000 (A)
At this time we also set up the “Accumulated Depreciation of Mill” contra-asset account, but do
not make any entries to it.

12/31/20X1 events and journals:

At the end of the next year, we need to reduce book value of the mill by 20% and incur an
expense for 20% of mill’s value. (IE: we need to report one year’s worth of wear). The
appropriate journal entries are:
dr Depreciation Expense $10,000 (E)
cr Accumulated Depreciation $10,000 (A)
We make no entry to the Mill Asset account at this time, and going forward we will continue to
measure wear of the mill through the Accumulated Depreciation account.

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

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

Income Statement:
Revenue $xxx
Expenses
COGS $xxx
Depreciation $10,000

12/31/20X2 events and journal entries:

Reduce book value of mill by 20%, incur expense for 20% of mill’s value.
dr Depreciation Expense $10,000
cr Accumulated Depreciation $10,000
Again we make to entry to the “Mill Asset” account.

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 6

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

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

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

Income Statement:
Revenue $xxx
Expenses
COGS $xxx
Depreciation $10,000

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

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

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

First, as usual, we need to reduce the book value of the mill by 20%, and incur an expense for
20% of mill’s cost:
dr Depreciation Expense $10,000 (E)
cr Accum. Depreciation $10,000 (A)

Next we zero-out the balance of the Mill Asset account and its pilot-fish Accumulated
Depreciation account, as the mill has completed its useful life:
dr Accum. Depreciation $50,000 (A)
cr Mill Asset $50,000 (A)

12/31/20X5 Financial Statements (partial):

Balance Sheet:
The Mill Asset and its contra-asset Accumulated Depreciation account are not shown as both
their balances are zero.

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 7

Income Statement:
Revenue $xxx
Expenses
COGS $xxx
Depreciation $10,000

Here are couple more good things to remember about depreciation:

1. Although we've usually thought of depreciation as a measure of wear over an asset's useful
life, its also good to think of if as a way to “match” the expenditure for the asset over its useful
life, per the Matching Concept.
2. For larger companies with many depreciable assets, reporting of them on financial statements
is aggregated. All depreciable plant and equipment, for example, is reported in a single “PPE”
account. Similarly, Accumulated Depreciation includes the total for all depreciable assets and
Depreciation Expense represents the total reduction in book value for all of these assets.

Now that we understand the mechanics of GAAP-style depreciation reporting, let's consider
some questions that shed light on the meaning, consequences and importance of depreciating
assets:
1. Should GCC throw away mill at EOY 20X5?
2. If GCC keeps using mill after 20X5, how will this impact its profitability?
3. Do depreciation expenses ever result in cash flows?
4. Does depreciation expense matter?

Answers:
1. Of course not! The mill's “useful life” of five years was just an accounting estimate. If the
actual mill is working properly at the end of its useful life and GCC still finds it helpful, the
firm should of course keep working with the machine.
2. All else equal, GCC's profits will go up after 20X5 because it will no longer incur a
depreciation expense for the mill. If the firm buys a new mill in 20X6, then of course they
will take a depreciation charge for this new machine.
3. No, depreciation does not cause a change in cash. As we've seen in the above journals, the
other side of a Depreciation Expense entry is always Accumulated Depreciation.
4. If depreciation is not ever associated with cash flows, should it matter? Is it just a fiction
used by the accounting profession to be obfuscational and help ensure accountants' job
security? Actually, in many cases depreciation does matter. This is especially true for large
companies in “steady state” mode (not growing to fast or redefining their business missions)
with many depreciable assets. For these firms, depreciation gives financial-statement
readers a decent estimate of how much an entity should spend to maintain its PPE. This can
be compared to an entity's reported Capital Expenditures (shown in the Investing section of
the Cash Flow statement), to see if the firm is under-investing in its PPE. Sustained under-

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 8

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

DEPRECIATION WITH SALVAGE VALUE

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

Let's see how GCC's accounting treatment of its mill would look if it assigned it some salvage
value. Let's say:
 GCC’s policy is to replace its mills every five years. (This policy stems from GCC's views
on technological obsolescence and the reduced reliability of its older mills).
 GCC estimates that the mill it buys on 12/31/20X0 for $50,000 could be sold to a refurbisher
for about $12,500 at EOY 20X5. IE: GCC assigns the mill a salvage value of $12,500.
Now GCC wants the book value of the mill to be $12,500 at the end of its useful life, instead of
zero. Accordingly, it will depreciate the mill by $7,500 per year. GCC get this amount by
applying this equation:
Book Value = (Cost – Salvage Value) / (Years of Useful Life)
IE: 7,500 = (50,000 – 12,500) / 5.
We may check that this is appropriate as follows:
a) $7,500 per year * 5 years = $37,500 total depreciation of the mill over its useful life.
b) $50,000 cost – $37,500 total depreciation = $12,500 book value = desired salvage value.
IE: after 5 years of depreciation at $7,500 per year, the book value of the mill will be $12,500, as
desired.

Now we can create annual journal entries and partial financial statements for the life of the mill.
12/31/20X0 events and journals:
GCC buys the mill, paying with cash.
dr Mill Asset (PPE) $50,000 (A)
cr Cash $50,000 (A)
At this time we also compute the annual depreciation amount, as shown above.
($50,000 – $12,500)/(5 years) = $7,500/yr

12/31/20X1 events and journal entries:

Reduce the book value of the mill by $7,500, and incur depreciation expense for $7,500.
dr Depreciation Expense $7,500 (E)
cr Accum. Depreciation $7,500 (A)

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 9

12/31/20X1 Financial Statements (partial):
Balance Sheet ($K, UON)
Mill Asset $50.0
Less Accumulated Depreciation ($7.5)
Book value of mill $42.5

Income Statement ($K, UON)

Revenue $xxx
Expenses
COGS $xxx
Depreciation $7.5

12/31/20X2 Journal entries:

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

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

Balance Sheet ($K, UON)
Mill Asset $50.0
Less Accumulated Depreciation ($15.0)
Book value of mill $35.0

Income Statement ($K, UON)

Revenue $xxx
Expenses
COGS $xxx
Depreciation $7.5

13/31/20X5 events and journals:

First, reduce book value of mill by $7,500, and incur depreciation expense of $7,500
dr Depreciation Expense $7,500 (E)
cr Accum. Depreciation $7,500 (A)

Then zero out the Mill Account and its Accumulated Depreciation contra-asset account:
dr Accumulated Depreciation $37,500 (A)
cr Mill Asset $50,000 (A)

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

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 10

dr Accumulated Depreciation $37,500 (A)
dr Equipment Held for Sale $12,500 (A)
cr Mill Asset $50,000 (A)

12/31/20X5 Financial Statements (partial):

Balance Sheet ($K, UON)
Assets
Equipment held for sale $12,500
The balances of the Mill Asset and Accumulated Depreciation are zero and therefore not shown.

Income Statement:
Revenue $xxx
Expenses
COGS $xxx
Depreciation $7,500

GAIN AND LOSS ON SALE

Now let's say that GCC sells the above mill in 20X6 for $13,000, paid in cash. The company
records this event as follows:
dr Cash $13,000 (A)
cr Equipment Held for Sale $12,500 (A)
cr “Gain on Sale of Equipment” $500 (E)

Here the Equipment Held for Sale is properly credited to zero the balance of the asset no longer
owned by GCC. Additionally, “Gain on Sale” is added to ensure (among other things) that the
fundamental accounting equation is satisfied and that debits equal credits for the recording of this
transaction. Gain on Sale or “Loss on Sale” entries are always used in this way whenever the
amount received does not equal the book value of the asset “Held for Sale.” Gain on Sale is used
when the amount received is more than the asset's carrying value, and Loss on Sale is applied
with the amount received is less than the asset's book value. Here are some important properties
of Gain and Loss on Sale entries:
 Gain (Loss) on Sale = Sale Price – Book Value.
 Gain and Loss on Sale are defined respectively to be forms of Revenue and Expense. (These
definitions make sense inasmuch as Gains increase equity and Losses decrease equity).
 On Income Statements, Gain (Loss) entries appear near the bottom (but above the income
tax line) in a section called “Other Revenue (Expense)” or “Non-Operating Revenue
(Expense),” or some similar name that a wise-alec company has cooked up.

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

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 11

Income Statement ($K, UON)
Revenue $xxx
Expenses
COGS $xxx
Depreciation $xxx
Other Revenue (Expense)
Gain on Sale of Equipment $0.5
Loss on Sale of Something Else ($xxx)
Tax $xxx
Etc.

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

EXAMPLE
At EOY 20X0, GCC has:
 Just bought a new CNC mill.
 A CFO who is planning to retire after six years (At EOY 20X6). The CFO has:
 A retirement bonus tied to GCC's Net Income in his last year of employment. (IE: the
bigger GCC's Net Income in 20X6, the bigger the CFO's retirement bonus).
 An unscrupulous demeanor.

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

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

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 12

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

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

C-Corporations (C-Corps) directly pay income tax on their Taxable Income (TI). (In the simplest
case, which is the only one considered in this text, a company's Taxable Income is the same as its
Earnings before Tax {EBT}). Federal C-Corp tax rates are set by Congress and the IRS.
Currently (in 2014) these rates vary from 15% to 35% of TI. Firms showing TI of $18MM or
more pay at the 35% rate; firms showing less pay less.

The optimal corporate structure for a given firm depends on its industry and its long-term
ownership intentions. Industry is an important consideration because only firms in certain
business lines may take advantage of REIT, MLP and BDC tax structures. Intent for long-term
ownership is important as follows:

All else being equal, firms may incorporate as LLCs or S-Corps to avoid the “double taxation” of
C-Corps. Double taxation occurs when a C-Corp issues dividends. Cash available to pay a
dividend comes from a company's accumulated Net Income. As we know from our study of
Income Statements, Net Income is profit remaining after tax is paid on EBT. This is the first
level of taxation.

When an entity chooses to pay its owners a dividend, the owners will pay 15% tax on this
“dividend income” to the IRS. This is the second level of taxation.

For an LLC or an S-Corp, the first level of taxation is absent, as the entity does not pay income
tax. (IE: its Earnings Before Tax is equal to its Net Income). Many firms therefore choose to
incorporate as LLCs or S-Corps, so their owners may enjoy lower overall taxes on their
dividends.

Despite the tax advantages that S-Corps and LLCs enjoy over C-Corps, firms may choose to
incorporate as C-Corps if they expect their a large number of stakeholders who may hold on to
their ownership stakes for a short period of time. This is exactly the ownership profile of most
publicly-traded companies, who may have millions of owners (stockholders) at any time, and see

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 13

5% to 20% of their stock (or more) change hands in a single day2. The more owners a non
income-tax-paying entity has during a year (including temporary holders such as short-term
traders), the more onerous its K1 reporting becomes. Also, many stock market participants may
have never heard of a K1, or may think of K1 as a Himalayan mountain better known as
Masherbrum. In either case they would be ill-equipped to file personal tax returns that include
K1 forms for every stock they traded throughout the year.

To minimize their and their owners' tax reporting hassles, the great majority of publicly-traded
companies organize themselves as C-Corps. Many quick-growing startup firms, aiming to enjoy
the best of both the LLC and C-Corp structures, initially form as LLCs and convert to C-Corps
before becoming publicly-traded entities.

As noted above, C-Corps pay tax on their Taxable Income, which is not necessarily the same
thing as GAAP Earnings Before Tax. Taxable Income is computed on a Tax Return, which is the
same as a company's Income Statement only in simple cases. Differences between the two are
caused by the differences between the GAAP and IRS rules for revenue and expense recognition.
In this text, we will assume simple cases. More complicated scenarios are treated in most
Intermediate Accounting books and virtually all Tax Accounting texts.

EXAMPLE: TAX REPORTING FOR GREEN CAR COMPANY

Here is a simplified GCC Income Statement, developed using its LLC corporate structure:
Revenue $25.0K
COGS Expense $16.9K
Net Income $8.1K

Let's now assume that GCC is:

 Organized as a C-Corp
 Pays income tax at 33% of Taxable Income (TI)
 Has Taxable Income that is identical to its Earnings Before Tax.

In this case we prepare GCC's Income Statement as follows:

1. Create a Pre-Tax Income Statement:

Revenue $25.0K
COGS Expense $16.9K
EBT ( = TI in this case) $8.1K

2. Compute Income Tax and create tax journal entries:

dr Tax Expense 0.33* $8.1K = $2.67K (E)
cr Accrued Tax $2.67K (L)

2 S-Corps are limited to 100 or fewer owners, so it is virtually impossible for this entities of this type to become
publicly-traded.

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 14

3. Use the above journals to create GCC's finalized Income Statement as a C-Corp:
Revenue $25.0K
COGS Expense $16.9K
EBT $8.1K
Tax Expense $2.7K
Net Income $5.4K

Note that Tax Expense is the last item before Net Income. This is traditional and considered
good practice.

Self Testing Tip:

Considering the above Income Statement and how it was created, do you think a firm should aim
to look financially-strong in the eyes of the IRS?

Solution:
No. Financial strength is measured by the IRS as Earnings Before Tax, with bigger meaning
stronger. The bigger GCC's EBT, the more tax it will pay, and the smaller its NI will become.

In general, most firms want to portray themselves to the IRS as weakly and sickly as possible,
within the boundaries of the law. By contrast, NI is what redounds to entities' owners, so firms
want to make this as big as possible.

Congress has provided many, often complicated ways for firms to look less profitable to the IRS
than they do to their shareholders. One example we've already discussed is MACRS
depreciation, which is allowed by the IRS on tax returns but is disallowed within GAAP for
Income Statements. (Straight line depreciation is used within GAAP instead). The net effect is
that, for certain years, companies may report much higher depreciation expenses to the IRS than
they report to their shareholders. This situation let congresspeople feel that they've helped
businesses prosper by reducing their tax burden. At the same time, it helps ensure the future of
the accounting profession – by creating such a complicated, tedious mess that that many
businesspeople won't attempt to sort it out by themselves3.

3 Interestingly, this situation is changing through the advent and rapid improvement of rule-based tax accounting
software such as TurboTax for Business and H&R Block Premium Business.

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 15

 ACCOUNTING CONCEPTS, CONTINUED
Recall our list accrual accounting concepts:
1. Accrual,
2. Duality,
…
10. Matching,
11. Consistency,
12. Materiality.
Lets finish our introduction of the concepts by covering Consistency and Materiality.

The Consistency Concept says two things:

1. Once an accounting method is adopted, it must applied consistently in future.
2. The same accounting methods and techniques must be used for similar situations.
The Concept implies that a business must refrain from changing its accounting policy unless it
has a compelling reason to do so. If a firm changes an accounting policy, it must disclose the
nature of change, the reasons for the change and the effects to its financial statements.

The Materiality Concept says that an accounting standard can be ignored if the net impact of
doing so has such a small effect on the financial statements that a reader of the financial
statements would not be misled. Note that this definition does not provide definitive guidance
in distinguishing material information from immaterial information, so it is necessary to exercise
judgment in deciding if a transaction is material. Here is an example illustrating material and
immaterial events:
FastDelivery Company records the wear of its truck over time (this being material to the
company's delivery business), but it does not bother to record the wear of it's pencils as they are
used and sharpened. (FastDelivery fully expenses the cost of its pencils as it buys them).

CHAPTER 8 – SGA, DEPRECIATION REVISITED AND TAXES PAGE 16

 CASE STUDY:
TAXATION OF INVESTMENT MANAGERS
AND ATHLETES

CHAPTER 9
 TAX COMPLICATIONS
The accounting tax treatments addressed in this text apply only to very straightforward
situations. Unfortunately, the U.S. tax codes are so complicated that straightforward situations
are rare in real life. The 2013 federal tax code, for example, weighs in at 73,954 pages. As a
result, entire graduate-level courses are devoted to taxation, in both accounting departments and
law schools.

Some tax complications arise from a desire for fairness, such as the ostensibly “progressive”
nature of the federal income tax code. Many tax idiosyncrasies are incorporated to accommodate
“special interests” and their lobbyists. These peculiarities are difficult to uproot partially because
the definition of “special interest” depends on the definer's interests. A good general definition
for a special tax interest might be any group who wants something in the tax code that you don't
like.

Here is an example of a special-interest-driven tax code anomaly. Look it over and see if you
think its fair and/or appropriate.

TAXATION OF ATHLETES AND INVESTMENT

MANAGERS
Most professional athletes are taxed as individuals. They pay income tax on their base salaries
and performance bonuses based on their individual tax returns.

Although private equity and hedge fund managers primarily earn income through the profits of
their investment firms, they are also taxed as individuals. This is because managers' investment
firms are usually organized as Limited Liability Corporations (LLCs), which generally pay no
income tax directly. Instead, an investment firm's profits are declared by its owners on their
personal tax returns, and taxed at the individual level.

Both professional athletes and investment managers may make millions of dollars per year,
putting them in the highest income tax bracket. Currently (2016) the top federal tax bracket is
35%, a rate that starts with incomes over $388,350 per year, as shown in this table:

Individual Federal Income Tax Rates (For 2016 tax, head of household):
 10% on taxable income from $0 to $12,400, plus
 15% on taxable income over $12,400 to $47,350, plus
 25% on taxable income over $47,350 to $122,300, plus
 28% on taxable income over $122,300 to $198,050, plus
 33% on taxable income over $198,050 to $388,350, plus
 35% on taxable income over $388,350.

CHAPTER 9 – CASE STUDY: TAXATION OF INVESTMENT MANAGERS AND ATHLETES PAGE 2

Most individuals, including professional athletes and investment managers, pay lower tax rates
on their investment gains than they pay on their income. “Capital” investment gains, defined as
sale price minus purchase price,1 are federally taxed as follows2:
 The tax rate is 15% for investments held for more than a year.
 For investments held for a year or less, the tax rate is the individual's income tax rate (35%
for most professional athletes, hedge fund and private equity fund managers).

Although most professional athletes, hedge fund and private equity fund managers are taxed as
individuals and share the same tax brackets, the investment managers may pay significantly less
tax. This is due to a quirk in the tax laws (or a special-interest exemption in the laws, depending
on your perspective) designed for the managers. Here is how it works:
When starting a fund, a manager will raise a large amount of cash from investors, who
become limited partners3 in his LLC. The manager will also invest some of his own cash,
but the lion's share of the funds invested is from the outsiders. The outside investors
typically agree to pay the manager an annual “asset management” fee of (say) 2% of their
invested balance, plus an annual performance bonus fee of (say) 20% of any gains made
during the year. A good manager will typically earn much more from their performance fee
than their asset management fee.

This pay structure looks a lot like the typical, base-salary plus performance-bonus pay
structure enjoyed by professional athletes. But while athletes pay income tax on both their
base-salary and their bonus, the investment manager typically pays income tax (35%) only
on his asset management fee. He pays tax on his usually-larger performance fee at just the
long-term capital gains rate (15%).

This lower tax rate for investment managers was enacted by Congress in 1954, when it declared
that managers' bonuses would be called “carried interest” by the IRS and taxed at the capital
gains rate. Several congressional attempts have been made to tax managers' performance fees
like everyone else, but to date (2013) these have been thwarted by hedge fund and private equity
managers and their lobbyists.

Further Reading
What is Carried Interest and How Should it be taxed?; Tax Policy Center of the Urban Institute
and the Brookings Institution.
http://www.taxpolicycenter.org/briefing-book/key-elements/business/carried-interest.cfm
Special Interest (The Financial Page); The New Yorker; James Surowiecki. March 15, 2010.
http://www.newyorker.com/talk/financial/2010/03/15/100315ta_talk_surowiecki

1 For example, the capital gain on a stock bought for $100K and later sold for $150K would be $50K.
2 Families earning less than about $70,000 per year pay no capital gains tax.
3 Limited partners do not have a say in how the LLC is run or how to manage its investment strategy.

CHAPTER 9 – CASE STUDY: TAXATION OF INVESTMENT MANAGERS AND ATHLETES PAGE 3

CHAPTER 9 – CASE STUDY: TAXATION OF INVESTMENT MANAGERS AND ATHLETES PAGE 4
CASH ACCOUNTING
CHAPTER 10
 ACCRUAL ACCOUNTING VS CASH ACCOUNTING

ACCRUAL ACCOUNTING
The two most foundational ideas of Accrual Accounting are arguably the Accrual Concept and
the Duality Concept. Here is a reminder of their definitions:

The Accrual Concept:

Measure financial events when accrued (when experienced or accumulated), regardless of when
cash transactions occur.

The Duality Concept:

Assets = Liabilities + Owners’ Equity,
at all times under all circumstances.
The Duality Concept also implies:
Δ(Assets) = Δ(Liabilities) + Δ(Owners’ Equity)
Where “Δ” means “change in” or “change to,” and change is measured over time.
IE: Δ(Assets) = Assets(T2) – Assets(T1), etc.

CASH ACCOUNTING
The mechanics of Cash Accounting can be developed around two similar concepts, and a change
to our definition of Owners' Equity:

The Non-Accrual Concept

This concept states two foundational rules in the Cash Accounting world:
 Measure financial events only when cash transactions happen.
 Do not recognize any accruals.
Because we are not measuring accruals in the Cash Accounting world, our only asset is cash
itself. Similarly, there are no liabilities in this system.

Owners' Equity
Equity is defined in the Cash Accounting system as follows:
Equity ≡ Cash
from which
Δ(Equity) = Δ(Cash).

CHAPTER 10 – CASH ACCOUNTING PAGE 2

As you see in these Accrual Accounting relations:
Equity ≡ Assets – Liabilities
from which
Δ(Equity) = Δ(Assets) - Δ(Liabilities)
The Cash Accounting definition of equity is similar to the Accrual Accounting definition. The
Cash Accounting definition is simplified as follows: “Liabilities” have been dropped because
they do not exist in the Cash world, and “Assets” has been replaced with “Cash,” which is Cash
Accounting's only asset.

The Cash-Accounting Duality Concept:

With the above definition, the Cash-Accounting version of the Duality Concept is simply:
Cash = Owners Equity, at all times, and
Δ(Cash) = Δ(Owners’ Equity), over all time periods.

In this system, equity accounts simply provide descriptions to changes in cash. Equity accounts
are grouped into Operating, Investing, and Financing buckets. Example accounts for each bucket
are:
 Operating
Cash revenues collected.
Cash interest paid or collected.
Cash paid for expenses.
 Investing
Payments for the purchase or sale of PPE.
Awarding a loan, or receiving repayment of loan principal.
 Financing
Receiving cash when taking out a loan or issuing bonds.
Repaying loan principal or bond principal.
Receiving Paid-in-Capital (PIC) from owners.
Paying owners dividends.

ACCRUAL VS CASH ACCOUNTING EXAMPLE: WEA

Lets complete a simple example to help us understand how Cash Accounting works in practice,
and how its financial statements compare to those created under Accrual Accounting rules.

Problem
Create cash-basis journals and Financial Statements for WEA’s first quarter of operations.
Compare and contrast these statements with those created under Accrual Accounting. For each
statement, explain which is superior (cash-basis or accrual) and why.

CHAPTER 10 – CASH ACCOUNTING PAGE 3

Events experienced by the company during the quarter:
1. The company is formed.
2. WEA's owners pay in $10,000 (PIC) for 10,000 shares.
3. The company buys $5,000 of furniture, computers “on account.” (“On account” means that
the company received an invoice).
4. The company invoices $8,000 in revenue. Customers paid $4,000 cash at time of invoicing
and agree to pay the remaining $4,000 within 60 days.
5. WEA incurs and pays Salary Expense of $3,000 and Rent Expense of $1,000.
6. The company pays its owners a dividend of $2,000.

Solution
Cash-Basis Journal Entries:
1. No entries (no change in cash).
2. DR Cash $10,000 (A)
CR PIC $10,000 (E)
3. No entries (no change in cash).
4. DR Cash $4,000 (A)
CR Revenue $4,000 (E)
5. DR Salary Expense $3,000 (E)
DR Rent Expense $1,000 (E)
CR Cash $4,000 (A)
6. DR DIV $1,000 (E)
CR Cash $1,000 (A)

CHAPTER 10 – CASH ACCOUNTING PAGE 4

Balance Sheets

Cash-Basis

Accrual-Basis

Comparing these two financial reports, its clear that the accrual Balance Sheet contains all the
information shown on the cash-basis report, plus additional information about accruals. For
example, WEA's accrual-basis statement shows that the firm owes its creditors $5,000, which is
left unreported on the cash-basis statement. So the accrual method is unambiguously best for
Balance Sheets.

Income Statements

Cash-Basis

Accrual-Basis

In this case its not so obvious which statement is best. Both Income Statements (ISs) show
revenue and all expenses for the period.

CHAPTER 10 – CASH ACCOUNTING PAGE 5

The cash-basis statement looks more conservative (and therefore maybe better) because it only
reports only the $4,000 of revenue that has actually been received. However, this is the same
'actually received' revenue that will be shown on WEA's Cash Flow Statement (see below).

The accrual-basis Income Statement includes the $4,000 of revenue declared and collected, plus
the additional $4,000 of revenue that WEA expects to collect in cash soon. The accrual
statement does not identify how much cash revenue is uncollected, but is easily obtained by
subtracting the collected revenue shown on the Cash Flow Statement from the total revenue
declared on the Income Statement. (IE: $8K total revenue - $4K collected in cash = $4K
uncollected).

As with its Balance Sheets, WEA's Accrual Accounting Income Statement provides us with
more useful information than its cash-basis cousin, if we use it in concert with the firm's Cash
Flow Statement. Also, as explained below, the cash-basis IS reports exactly the same information
as the Operating section of WEA's Cash Flow Statement, making it redundant. So once again we
conclude that the Accrual Accounting report is superior to its cash-basis alternate.

Cash Flow Statements

Cash-Basis and Accrual-Basis

Since the Cash Flow Statement only reports changes in cash, this report is the same in the Cash
Accounting and Accrual Accounting worlds. As you can see, the Operating section is identical to
the cash-basis Income Statement.

CHAPTER 10 – CASH ACCOUNTING PAGE 6

 WHY BOTHER WITH CASH ACCOUNTING
Despite the drawbacks of Cash Accounting that we just highlighted, it is useful under some
circumstances and is used by many entities. It has the benefit of being simple to understand and
quick to use, making it perfect for small, unleveraged service (consulting) entities with cash-like
sales and small amounts of non-cash assets.

A good example of a firm for which Cash Accounting is better than Accrual Accounting is Valu-
It LLC, a several-person appraiser in Manhattan. Value-It gets paid by cash or check on delivery
of its appraisals. The firm's main asset is the knowledge of its appraisers (which is not a GAAP-
qualified asset). The entity does not own a car or a place of work, choosing instead to have its
employees travel by subway and taxi, and to rent office space month-to-month. Valu-It has no
loans or other significant liabilities except unpaid bills for monthly rent, etc.

In this case, savings to the firm in time and accounting expertise far outweigh any small benefits
of carefully tracking its monthly rent-related accruals. This is generally true for firms with
mostly cash assets and few liabilities.

On the other hand, the more non-cash assets and liabilities an entity has, the better Accrual
Accounting is for it. Firms benefiting from Accrual Accounting include virtually all industrial
and financial entities, and service companies with large amounts of non-cash assets (like HCP) or
liabilities (such as firms with significant borrowings).

The IRS requires that any C-Corporation with more than $5MM in revenue use Accrual
Accounting. Similarly, the Securities and Exchange Commission (SEC) requires all filing
entities to use Accrual Accounting.

CHAPTER 10 – CASH ACCOUNTING PAGE 7

CHAPTER 10 – CASH ACCOUNTING PAGE 8
COMPREHENSIVE ACCOUNTING
EXAMPLE

CHAPTER 11
 AMERICAN COMMUNITY PROPERTIES
EXAMPLE
Lets tie together almost everything we've learned about financial accounting into one big, real-
world example.

Consider American Community Properties (APO), founded in 1997 and headquartered in St.
Charles, MD. APO's primary business is the purchase, upgrading and reselling of detached and
multi-family homes. The company also owns multifamily, multistory buildings and rents
apartments in them.

As a home refurbisher and lessor, APO has characteristics of both industrial and service
companies. Its refurbishing business features the inventory assets of industrial firms, and its
landlord operations earn revenue through the service of providing habitable space.

Lets follow APO through the year 20X1. We will use its latest Balance Sheet, its 20X1
economic events and additional information to create a full set of journal entries and financial
statements for the year. Here is everything we'll need:

Balance Sheet ($MM UON)

APO, Inc. Year 20X0

Assets Liabilities
Current (All Long Term)
Cash $3,000 Loan Payable $4,000
Equip. Held for Sale $1,000 Total Liabilities $4,000

Long Term Equity

PPE $10,000 PIC $4,000
- Accum. Deprec. -$5,000 RE $1,000
= PPE Book Value $5,000 Total Equity $5,000

Total Assets $9,000 Liabilities+Equity $9,000

Notes at BOY 20X1:

 APO’s PPE has average useful life of 16 years, with $2,000MM salvage value.
 The firm's PPE has already accumulated, on average, 8 years of depreciation.
 APO uses linear depreciation.
 The loan shown on the 20X0 Balance Sheet carries an annual interest rate of 7%
(compounded annually). The principal is due to be repaid in 20X3.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 2

 The cumulative net income of the company, since inception, is $2,000.

20X1 Economic Events:

1. APO purchased inventory (homes) costing $34,000 on account. (IE: was invoiced at time of
purchase).
2. Sold/invoiced $37,000 worth of homes to customers. (APO ‘matches’ certain expenses to
revenue at the end of each accounting period, rather than with each sale).
3. Received $1,000 in cash prepayment for services it promises to deliver in 2008.
4. Noted that its Cost of Goods Sold for the year was $30,000.
5. Received $33,000 in payments on previously-submitted invoices.
6. Paid $29,000 of outstanding vendor invoices.
7. Noted need to pay and paid $5,000 to rent office space for the year and for other
administrative costs.
8. Prepaid $3,000 for 20X2 office space rent.
9. Noted depreciation on all its PPE assets.
10. Noted and paid 20X1 interest on its Loan Payable.
11. Noted that $1,000 worth of inventory was destroyed and useless as inventory but retained
$500 in salvage value.
12. Took out a loan for $5,000 and used this cash to purchase 100% of BabyRealty.
BabyRealty’s Balance Sheet (MV) at the time of sale was:
PPE: $10,000, AP: $6,000, Equity $4,000
13. Sold its $1,000 Equipment Held for Sale for $700 cash.
14. Estimated (noted) its 20X1 Tax Expense at $147.
15. Paid its owners a dividend of $100.

RECORD JOURNAL ENTRIES FOR THE ECONOMIC EVENTS

We start solving this example by creating journal entries for the firm's 20X1 economic events.
Journal entries for simple events that we have covered previously are listed without comment.
Explanations are provided for new and more complicated events.

Speed Learning / Self Testing Tip:

Before reading through this section, I strongly suggest that you try to create journal entries on
your own from the events listed above.

1. APO purchased inventory (homes) costing $34,000 on account (IE: was invoiced at time of
purchase).
dr Inventory $34,000 (A)
cr AP $34,000 (L)

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 3

2. Sold/invoiced $37,000 worth of homes to customers. (APO ‘matches’ certain expenses to
revenue at the end of each accounting period, rather than with each sale).
dr AR $37,000 (A)
cr Revenue $37,000 (E)

3. Received $1,000 in cash prepayment for services it promises to deliver in 20X2.

dr Cash $1,000 (A)
cr Unearned Revenue $1,000 (L)
The cash received is a liability until APO provides the promised services.

4. Noted that its Cost of Goods Sold for the year was $30,000.
dr COGS Expense $30,000 (E)
cr Inventory $30,000 (A)
Here APO looks up its sales for the year, and matches its COGS Expense to the cost of the
inventory that it sold during the year.

5. Received $33,000 in payments on previously-submitted invoices.

dr Cash $33,000 (A)
cr AR $33,000 (A)

6. Paid $29,000 of outstanding vendor invoices.

dr AP $29,000 (L)
cr Cash $29,000 (A)

7. Noted need to pay and paid $5,000 to rent office space for the year and for other
administrative costs.
dr SGA Expense $5,000 (E)
cr Cash $5,000 (A)
Here we use SGA Expense because the event includes “other administrative costs.” Without
knowing what the other admin costs are, we cannot specify these expenses more precisely.

8. Prepaid $3,000 for 20X1 office space rent.

dr Prepaid Expense $3,000 (A)
cr Cash $3,000 (A)
Prepaid Expense is an asset because, in our assumed loving world, APO could ask for a
refund for the prepaid rent before it used the office space. We also assume that, as the year
20X1 progresses, APO could ask for a refund for any unused rent payment. So, the prepaid
assets declines linearly to the value of zero at the end of 20X1.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 4

9. Noted depreciation on all its PPE assets.
dr Depreciation Expense $500 (E)
cr Accumulated Depreciation $500 (contra A)
The $500 is calculated as follows:
$500 = ($10,000 total PPE) - ($2000 salvage value)
(16 years)

10. Noted and paid20X1 interest on its Loan Payable.

dr Interest $280 (E)
cr Cash $280 (A)
The $280 is computed from:
280 = 7% of 4,000 loan balance at BOP.

11. Noted $1,000 worth of inventory was destroyed and useless as inventory but retained $500
in salvage value.
dr Misc. Asset (from Inventory) $500 (A)
dr Inventory Write-Down $500 (E)
cr Inventory $1,000 (A)
As always, when an asset is written down, the net amount written off is taken as a Write-
Down or Write-Off Expense. In this case, $500 worth of the inventory will be sold to a
salvager. The $500 write-down could be attributed to either Inventory Write-Down or
COGS Expense. As we have learned previously, it is preferable to use inventory write-down
(to provide readers with more specificity), and GAAP suggests that all large inventory write-
offs should be explicitly called out and not folded into COGS.

12. On the last day of the year, APO took out a long-term loan for $5,000 and used this cash to
purchase 100% of BabyRealty. BabyRealty’s Balance Sheet (market value basis) at the time
of sale was:
PPE: $10,000, AP: $6,000, Equity $4,000.
First take out the loan:
dr Cash $5000 (A)
cr Loan (long-term) $5000 (L)
Then take ownership of BabyRealty, and absorb the firm's accounts into those of APO's:
dr PPE $10,000 (A)
dr Goodwill $1,000 (A)
cr AP $6,000 (L)
cr Cash $5,000 (A)
When APO buys BabyRealty, it takes on all of this firm's assets (marked to their market
values) and liabilities. We see this from the PPE and AP entries above. APO also pays
BabyRealty's prior owners as seen in the credit to cash. At this point total debits are less
than total credits by $1,000. This amount, representing the amount paid for BabyRealty
over the market value of its equity, is ascribed (as always) to APO's Goodwill account.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 5

 An example showing how to establish Journal entries for a more general-case merger, where
the purchased firm has cash on its balance sheet, is given at the end of this chapter.

Good to Know:
When evaluating APO's future Balance Sheets, many value investors will set the firm's
Goodwill amount to zero, on the assumption that APO overpaid for BabyRealty by this
amount. A significant body of academic research supports the view that purchasers usually
overpay for the firms they buy.

13. Sold its $1,000 Equipment Held for Sale for $700 cash.
dr Cash $700 (A)
cr Equipment Held for Sale $1,000 (A)
cr Loss on Sale of Equipment $300 (E)
Here the difference between the equipment's book value (or “holding value”) and sale price
realized is ascribed to equity in the Gain on Sale or Loss on Sale account. In this case, Loss
on Sale is the proper account because the realized sale price was less than the holding value.
Gain or Loss on Sale will appear on APO's Income Statement in the Other Revenue/Expense
section. The cash of $700 will be an Investing flow on APO's Cash Flow Statement, as the
items sold was equipment, presumably retired from APO's PPE.

14. Estimated (noted) its 20X1 Tax Expense at $147.

dr Income Tax $147 (E)
cr Accrued Tax $147 (L)

15. Paid its owners a dividend of $100.

dr Dividend $100 (E)
cr Cash $100 (A)

Here is the complete set of journal entries:

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 6

CREATE THE EOY 20X1 BALANCE SHEET
As you (hopefully) recall, a Balance Sheet shows the total balance for each account represented,
including all journal entries from the inception of the firm. It is a level report (showing total
levels of each account), not a flow report.

A good way to start building a Balance Sheet is to create a table that includes all the BOP
balances (IE: all the items shown on the 20X0 Balance Sheet), and all the account entries for the
events experienced in 20X1. The table's entries should be sorted first by assets, liabilities and
equity, then by account. For each account with a BOP balance, the BOP balance should be the
first entry.

Speed Learning / Self Testing Tip:

For this Balance Sheet and all of APO's other 20X1 financial statements, you should
independently complete each step needed to create the statement, then check your results with
the information shown here.

Here is the completed table, with BOP balances called out and written in blue:

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 7

Working from this table, we easily complete the Balance Sheet by:
 Subtotaling each asset and liability account.
 Subtotaling revenue, expenses and dividends into Retained Earnings, and adding this
amount to this account's BOP balance.
 Writing our results out in Balance Sheet format.
 Checking that the Fundamental Accounting Equation:
Total Assets = Total Liabilities + Total Equity
holds true for this new, 20X1 Balance Sheet.

Here is the completed Balance Sheet:

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 8

As always, Balance Sheet format includes the display of the entity's name, the declaration that
the report is indeed a Balance Sheet with the accounting period, and the currency units utilized.
“UON” stands for “Unless Otherwise Noted.” It is not necessary to lay out assets in a separate
column from liabilities and equity. I chose a two-column layout in this case simply for its fit on
the page.

CREATE THE 20X1 INCOME STATEMENT

Income Statements (like Cash Flow Statements and Statements of Owners' Equity) are flow
reports, that focus primarily on changes during the accounting period being reported. Income
Statements do not show BOP or EOP balances at all.

We can quickly create a 20X1 Income Statement for APO from the above table that we
developed for APO's 20X1 Balance Sheet. Note that in the equity section, all of APO's revenue
and expenses for 20X1 are listed. Here is the equity portion of the table, with non-Income
Statement entries crossed out:

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 9

 Recall that BOP balances are not shown on
Income Statements and dividends are not
expenses. Therefore these entries are
crossed out.

In general, to create APO's Income Statement, we simply subtotal the Income Statement items by
account and rewrite this information in Income Statement format. In this example, no
subtotaling is required.

Here is APO's Income Statement for 20X1:

Here “Loss on Sale” is set in its own section, “Other Expense.” This is considered good practice,
and is a practice you should follow.

Also, I've subtotaled by “EBIT,” which stands for “Earnings Before Interest and Tax.” This
subtotal is not required for Income Statements, but it is fairly common. Other common subtotals

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 10

include “EBT” (Earnings Before Tax) and EBITDA (Earnings Before Interest, Tax, Depreciation
and Amortization).

Finally, this Income Statement, like most, does not employ an algebraic sign convention. The
reader is expected to know that expenses are subtracted from revenues.

CREATE THE OWNERS’ EQUITY STATEMENT (OES)

We can again use the table we created for the Balance Sheet to complete an Owners' Equity
Statement for APO. Here is the equity portion of the Table, showing revenue and expenses
condensed into Net Income:

To build the OES, we also must divide the BOP Retained Earnings into its Net Income and
Dividend components. Recall that:
Retained Earnings ≡ Net Income – Dividends
Also, we are told that APO's cumulative Net Income through 20X0 is $2,000. Using this and the
BOP Retained Earnings in the table of $1,000 yields:
Retained Earnings ≡ Net Income – Dividends
$1,000 = $2,000 – Dividends issued through BOP
From which Dividends through BOP = $1,000.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 11

With this information and APO's BOP Balance Sheet, we have everything we need to create the
firm's 20X1 Owners' Equity Statement.

Here is the statement in OES format:

After creating the statement, the first thing we should check is that the EOP equity balance
matches the Equity balance on APO's 20X1 Balance Sheet. $5,173K is in fact the amount on the
Balance Sheet. Also note that:
 BOP balances are taken from APO's BOP Balance Sheet and the above calculation for BOP
dividends.
 Each row is totaled into the equity column, and each column is totaled into the EOP Balance
row.
 The $5,173 total of the EOP Balance row entries matches the total of the equity column
entries.
 The EOP balances for PIC and NI + Div match the PIC and Retained Earnings numbers on
APO's 20X1 Balance Sheet.

CREATE THE (DIRECT METHOD) CASH FLOW

STATEMENT (CFS)
To create APO's 20X1 direct method Cash Flow Statement, we must work from its journal
entries (or transaction table entries) for the period. Our process starts by finding each cash entry,
noting the reason that cash flowed, and designating the flow as Operating, Investing or
Financing.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 12

Here are the journal entries with cash transactions highlighted according to their type. Operating
flows are shown in red, Investing in green, and Financing in blue.

The next step is to sort by Operating/Investing/Financing, to subtotal by reason for flow, and to
replace the dr/cr indicators with algebraic + and – signs.

For each flow, I've replaced the account reported in the journal entry with the reason for the cash
flow. So for example, the $1,000 cash inflow associated with Unearned Revenue (Event 3) has
been labeled “Advances from Customers.” There is no exact rule labeling each flow. Any

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 13

description that reasonably describes why cash moved in or out is fine. (The description of the
economic event that precipitated a cash journal entry's creation is usually a fine explanation for a
cash flow).

As our last step, we put the above information, along with APO's BOP and EOP cash balances,
into Cash Flow Statement format:

The BOP cash balance is taken from APO's 20X0 Balance Sheet. The EOP balance is checked
against the cash shown on the firm's EOP Balance Sheet.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 14

 PURCHASING ENTITIES WITH
CASH ON THE BALANCE SHEET
Consider this purchase:
M & I Homes (MHO, a competitor of CTX and APO) takes out a (long-term) loan for $4,000
and uses this cash to purchase 100% of NicheRealty. The transaction is completed on the last
day of the year.
NicheRealty’s Balance Sheet (with assets at market values) at the time of the transaction is as
follows:

Assets (Market Values) Liabilities and Equity

Cash: $1,000 AP: $6,000
AR: $1,000
PPE: $6,000 EquityMV: $2,000

Find journal entries, an Income Statement and a Cash Flow Statement for this purchase.

Solution:
Journal Entries:
1. Take out the loan:
dr Cash $4,000 (A) (a Financing Cash Flow)
cr Loan Payable $4,000 (L)

2a. Get NicheRealty’s Assets (at market values) and Liabilities, and establish Goodwill:
dr Cash $1,000 (A) (An Investing CF)
dr Accounts Receivable $1,000 (A)
dr PPE $6,000 (A)
dr Goodwill $2,000 (A) (Price paid - Equitymv)
cr Accounts Payable $6,000 (L)
The acquisition of cash is an Investing flow because its an asset being purchased along with
the rest of NicheRealty's assets. This amount cannot be used to reduce the loan taken to buy
the company, because it is being used to support NicheRealty's daily operations. Think of
this as cash held in NicheRealty's cash registers and petty-cash jars.

2b. Pay for NicheRealty:

cr Cash $4,000 (A) (An Investing CF)

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 15

Income Statement:
(for the Accounting Period covering just this transaction):
Revenue $0.0
Expense $0.0
No normal, day-to-day business occurred during the period.

Cash Flow Statement:

(for the Accounting Period covering just this transaction):

Cash Flow from Operations $0.00

Cash Flow from Investing

Acquisition of NicheRealty ($3,000)

Cash Flow From Financing

Loan Proceeds $4,000

The Cash Flow from Investing is computed as follows:

Cash Asset Obtained in Acquisition $1,000
- Cash Paid for Acquisition ($4,000)
= Net Cash Flow from Acquisition of NicheRealty ($3,000)

An alternate representation of the Cash Flow from Investing is:

Cash Flow from Investing
Payment for Purchase of NicheRealty ($4,000)
Cash of NicheRealty's Obtained in Purchase $1,000

Either representation is OK. The second method may be considered preferable, because it
provides more information and facilitates matching of the Loan Proceeds to the Payment for
Purchase.

CHAPTER 11 – COMPREHENSIVE ACCOUNTING EXAMPLE PAGE 16

 FINANCIAL STATEMENT ANALYSIS
PART I:
INFORMATION AND INSIGHTS DERIVED
FROM FINANCIAL STATEMENTS
CHAPTER 12

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 1

 INTRODUCTION TO
FINANCIAL STATEMENT ANALYSIS
Now that we have recalled so much about accounting techniques and statements, lets use this
knowledge to analyze companies. As we have seen, accounting information helps us answer
important financial questions, such as:
§ Should we make an equity investment in this company?
§ Should we make the company a loan?
§ Is the company better off than its comparables (“comps”)?
In this chapter we will apply Ratio Analysis methods to accounting reports to answer these and
other questions more clearly and completely than we’ve been able to until now. We’ll formulate
our work in ways that help us understand a company's financial state relative to its history and its
comps, as well as to industry-specific and macro-economic conditions.

ASSESSING ENTITIES' FINANCIAL PERFORMANCE

THROUGH THE GREAT RECESSION
Its interesting to look at companies' financial performance during the Great Recession (roughly
Dec 2007 through June 2009), to see how well they handled this extreme economic downdraft.
The performance of airlines during the recession is particularly intriguing: Many “legacy” (old)
airlines such as United Airlines (UAL) entered the recession in a weak state, and were hammered
by:
 Their high fixed cost structure, due in part to their great variety of old planes with inefficient
engines, and their unsustainable union contracts.
 Lots of debt relative to their ability to repay it.
 Difficulty competing with new, low-cost rivals, such as Southwest, Alaska Air and JetBlue.
 A struggle to cope with the skyrocketing cost of jet fuel1, which was caused by stagnant
global supply, the ongoing Iraq war, and escalating demand in developing countries.
Most of these entities ended up in bankruptcy court, but several of them, such as UAL,
surprisingly lived to fight another day.

1 Demand was especially growing in China, where it was increasing by about 8% per year at the start of the
recession. As a result of this supply/demand imbalance, the price of jet fuel increased from $1.65 per gallon in
January 2007 to $3.89 per gallon in July of 2008. The price subsequently declined as the worldwide recession
reduced global demand.
http://www.indexmundi.com/commodities/?commodity=jet-fuel&months=120.
“Causes and Consequences of the Oil Shock of 2007-08.” James Hamilton.
http://dss.ucsd.edu/~jhamilto/Hamilton_oil_shock_08.pdf

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 2

By contrast, some relatively new, “low cost” airlines – including Southwest and Alaska Air –
entered the recession in a strong financial position and were relatively unaffected by it. In this
chapter we use Ratio Analysis to compare and contrast United’s and Southwest's financial
journey through the Great Recession.

Daily peak
close price
= $147/bbl
in July.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 3

 RATIO ANALYSIS
Ratio Analysis builds ratios that provide important insights, irrespective of the individual items
and financial statements that they are assembled from. Here is a quick example. Consider the
Asset Efficiency Ratio:
Asset Efficiency≡ Revenue
Ratio Total Assets(BOP)
This ratio employs quantities from two different financial statements (the Income Statement and
the Balance Sheet) and two different accounting periods. It measures how many dollars of sales
an entity generates in a period from the assets it held at the beginning of the period.

Ratio Analysis is often used to simultaneously analyze a company's performance relative to its
history and to one of more comparable companies (one or more “comps”). When comparing to
comps, it's important to include only truly-comparable companies, not simply competitors. This
is because some competitors may not be directly comparable. For example, two of the world's
largest aircraft leasing companies are International Lease Finance and GE Capital. International
Lease Finance (ILF) is 100% devoted to the business of leasing aircraft. GE Capital, by contrast,
operates in the Consumer Finance, Energy Services and Real Estate businesses, in addition to
Aircraft Leasing. This “pollutes” GE Capital's financial date with date from three businesses
unrelated to aircraft leasing. Its financial statements are therefore not comparable. to ILF's, and it
is not considered to be one of ILF's comps.

ILF and GE Capital can be properly compared by extracting GE Capital's aircraft leasing data
from its overall financial statements. GE Capital provides this breakout on some of its filings
with the SEC, such as its annual, 10K reports.

Other issues that may keep competing companies from being comps are large differences in size,
or little overlap in geographic or demographic market segments. In the real world, finding true
comps is sometimes virtually impossible; in these cases its usually worth comparing competitors
that are as comparable as possible.

EXAMPLE : COMPARABILITY OF UNITED

AND SOUTHWEST AIRLINES

Lets check the comparability of United (UAL) and Southwest (LUV). UAL's key features (as of
2008) are:
 Being a full service airline, offering first-class, business-class and economy seats.
 Annual sales of about $15BB.
 Operating in the U.S. and international markets.
 “Hub and spoke” logistics, with primary hubs in Newark NJ, Houston TX, and Cleveland
OH.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 4

LUV's primary characteristics (again as of 2008) include:
 Being a low cost airline, offering only economy class and no reserved seats.
 Annual revenue of about $10BB
 Operating only in the U.S.
 “Point to point” logistics, with no hubs.

By comparing each company's characteristics, we see that UAL and LUV are not perfectly
comparable. Their market positioning (full service vs low cost) and geographic domains are not
an exact match, and their logistical strategies are opposite. Nonetheless, they are both American-
flagged carriers devoted solely to moving passengers and cargo by air. Also, their annual sales
are the same order of magnitude, and big enough to make them significant players in the U.S.
airline industry. So on balance, we will conclude that a comparative Ratio Analysis will be
useful.

Good to Know:
In financial statement analysis, and throughout finance generally, the differences and changes
that matter are usually big, and small changes and differences may often be ignored. This is
because there are many variables contributing to financial performance, and most of them are
somewhat unpredictable. As a result, we can often focus on big differences and changes to the

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 5

exclusion of other “noise.” This is in contrast to some other fields of study, like many
engineering disciplines, where small differences and changes are important and numbers must be
monitored to many significant figures.

Before we start analyzing the companies, we also need to decide how to compare their financial
quantities across time periods. In particular, should we compare quarter by quarter (quarter
ending 3/31/2008 to quarter ending 12/31/2007) or year over year (quarter ending 3/31/2008 to
quarter ending 3/31/2007)?

The answer depends on whether or not UAL and LUV are “seasonal” companies. Seasonal
entities experience peaks and troughs in revenues and/or costs during various times of the year.
Non-seasonal companies generally experience steady sales and costs throughout the year. Retail
banks are good examples of non-seasonal companies.

Like most airlines, UAL and LUV experience their biggest sales at particular times of the year,
such as the summer vacation season, when many consumers travel. So we can safely conclude
that both companies are seasonal and we should compare their numbers for each quarter to their
year-ago counterparts.

Don't worry if this was not obvious to you – you can always look it up. Publicly-traded
companies like UAL and LUV report their seasonality (or lack thereof) in annual filings to the
Securities and Exchange Commission (SEC) called 10-K reports. UAL's filing from 2008, for
example, states:
Due to greater demand for air travel during the summer months, our revenue in the second
and third quarters of the year is generally stronger than revenue in the first and fourth
quarters of the year. Our results of operations generally reflect this seasonality,…

You could also try to determine if UAL and LUV are seasonal by plotting their quarterly
revenues. This technique works for steady-state companies in steady-state economic conditions.
It does not work well for volatile companies during volatile economic periods, because
seasonality in revenues may be masked by sales swings from other causes.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 6

CLASSES OF RATIOS AND KEY RATIO TAKEAWAYS
There are five important classes of ratios:
1. Revenue and Revenue Growth Ratios.
2. Margin Ratios.
3. Efficiency (Turnover) Ratios.
4. Financial and Operating Leverage Ratios.
5. Liquidity Ratios.
There are three important takeaways for any ratio, irrespective of class:
a. The ability to articulate the meaning of the ratio in one short sentence, in a way that
underscores its usefulness.
b. Understanding whether a bigger value or a smaller value implies better performance.
c. Knowing whether or not a given ratio has a knife-edge value, separating good from bad
performance.

Lets look at all five classes of ratios, starting with Revenue and Revenue Growth.

1. REVENUE AND REVENUE GROWTH RATIOS

There are at least two good reasons to consider a company through the prism of its sales and
sales growth. First, sales is the cardinal measure of the size or scale of a firm. Annual revenue is
almost always the answer to the question, “how big is the firm?” This is true notwithstanding the
obsession with “market capitalization” (stock share price times number of shares outstanding)
seen on the worst of the financial news networks.2 Second, many changes in a company's
performance over time are simply due to its sales growth or decline.

For seasonal companies like UAL, revenue growth in the most recently-reported period is
measured as follows:
Quarterly Growth: (RevenueQ1 – RevenueQ5) / RevenueQ5
Annual Growth: (RevenueY1 – RevenueY2) / RevenueY2
Where Q1 is UAL's most recently reported quarter, Q5 is the year-ago quarter, Y1 is UAL's
most recently reported year, and Y2 is the prior year.

For non-seasonal companies, annual revenue growth is measured as above, and quarterly growth
is measured as:
Quarterly Growth: (RevenueQ1 – RevenueQ2) / RevenueQ2

2 It is also fair for some purposes to measure the size of a firm with a Balance Sheet metric. Even in these cases,
measuring size by market capitalization is useless. This is because two comparable firms in the same industry
may have the same annual sales and total assets, but wildly different market capitalizations. The two firms are
nonetheless the same size by any reasonable measure. The companies' differing market caps stem from different
choices related to raising capital with debt vs equity. These choices are analyzed in subsequent chapters.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 7

 Where we compare the sales of sequential quarters.

REVENUE RATIOS EXAMPLE:

UNITED AND SOUTHWEST
Consider this Revenue and Revenue Growth information for UAL and LUV3:

To read the table, note that:

 Q1 is the quarter ending 6/30/2008.
 Q2 is the prior quarter (ending 3/31/2008), Q3 is the quarter prior to Q2, etc.
 TTM stands for “Twelve Trailing Months.” In this case, where the date is measured
quarterly, this translates into four quarters worth of data
(IE: TTM = Q1 + Q2 + Q3 + Q4).
 Each data item is represented in two rows. The first row shows data for UAL, and the
second row, labeled “Comps” holds data for LUV.4
 Sales Growth for these seasonal companies is measured year over year.
(IE: UAL's Q4 Sales Growth of 8.58% = ($3,820 - $3,518) / $3,518).

The table provides us with some good insights, such as:

 As noted previously, the annual sales of the companies have the same order of magnitude,
helping to affirm their comparability.
 Both companies are growing sales nicely on a TTM basis. On a quarterly basis, they are
both also growing sales, but with more volatility. This information give us a heads up that
other problems we may find, like poor profitability, will not be caused by revenue declines.

We saw above how quarterly Sales Growth is computed for these and other seasonal companies.
Now lets calculate UAL’s Q1, TTM Sales Growth:
TTM Sales Growth of 10.3% = {14,957 – (3,518 + 3,156 + 3,179 + 3,710)}
(3,518 + 3,156 + 3,179 + 3,710)

3 All of UAL's financial statements used to prepare this table and the remaining ratio tables in this chapter are
located in the chapter's appendix.
4 The Ratio Analysis data in this chapter is compiled from a proprietary database/spreadsheet package. In this
software, “Comps” information may be sourced from a single company such as LUV, or an amalgam of many
comparable companies. This feature allows users to benchmark a company to a single comp, or to a collection
of comps that represent the average performance of an entire industry.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 8

2. MARGIN RATIOS
Our second class of ratios is Margin Ratios, which measure an Income Statement (IS) or Cash
Flow Statement (CFS) quantity relative to another quantity drawn from either of these
statements. Mathematically, we define Margin Ratios as:
Margin Ratio ≡ IS or CFS term
Another IS or CFS term
Almost always, the denominator of a Margin Ratio is Revenue for a period or periods.

Net Income Margin

The most common Margin Ratio is the Net Income Margin (NI Margin) or Profit Margin, defined
as:
NI Margin ≡ Net Income
Revenue
It represents the amount of Net Income that a company yields from its sales, usually expressed as
a percent. It may be measured over any accounting period, as long as the period for NI is the
same as for Revenue. Bigger is better for this ratio, as the more NI a company can extract from
its sales, the better.

The NI Margin is directly useful to potential investors. When comparing two companies, a debt
or equity investor may choose, all else being equal, to invest in the entity with the highest NI
Margin.

Most company managers and executives are interested in how they can increase their Profit
Margin. We can see how to improve the ratio by simply considering the effect of its numerator
and the denominator. Clearly, a Profit Margin will be improved when an entity's Net Income is
increased, or when its Revenue is decreased. Unfortunately, Net Income and Revenue are not
independent (NI = Revenue – Expenses), making it difficult to decrease sales without also
decreasing NI, and vise-versa.

An operational approach to increasing Profit Margins is to decrease expenses without decreasing

sales. This will augment Net Income and increase the Profit Margin Ratio. For example, UAL
could replace its old, inefficient jet engines with new efficient models. This would lower its fuel
expense without having any impact on its sales.

A strategic approach to increasing Profit Margins is to decrease sales of poorly-performing or

“low margin” businesses. In this way, Revenue reduced more than Net Income, which produces
a net increase in the Profit Margin.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 9

EXAMPLE:
STRATEGICALLY CUTTING SALES TO IMPROVE PROFIT MARGINS
(WITH AN INTRODUCTION TO INVESTMENT BANKING)
Imagine that you are the proud owner/operator of Vermont Organic Apples, a small-time grower
and distributor of high-quality apples. While hanging out at the Uncommon Grounds coffee
shop you are accosted by your local investment banker, who shows you how to improve your
business with this presentation:

First, he reminds you of your farm's recent overall performance:

Vermont Organic Apples Q4 20X0

Income Statement ($K UON)
Revenue 20
COGS 14
Other Expenses 1
NI 5
NI Margin 5/20 = 25%

Then he breaks out the farm's performance by your two product lines (apples sold as-is, and
apple butter), and shows you what it would look like without the apple butter business.

IS Apples + A. Butter = Total Only

Item Business Business ($K) A. Butter
Revenue 10 10 20 10
COGS 5 9 14 5
Other Exp.* NA NA 1 1
NI 5 4
NI Margin 25% 40%

* Office, accountant, etc.

He points out several things:

 As you can see from above statement
 Although your apple butter business has the same revenue as your apples as-is business,
it carries almost twice as much COGS expense.
 You could almost double your profit margin – moving it from 25% to 40% – by simply
dropping your low margin, apple butter business.
 The apple butter business is high risk. If, for example, a batch is made improperly, it could
grow the Botulinum toxin and give your customers botulism. This would cause pain,
sadness and death in your community, as well as the bankruptcy of your farm.
 As a farmer, you would be better off “sticking to your knitting” by concentrating on growing
and selling farm products, and leaving the processing of foods to food processing experts.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 10

 For an only-nominally-outrageous fee, he and his firm would be happy help you sell the
risky, under-performing apple butter business, and find ready markets for your new surplus
of apples.

The banker has properly pointed out how you can improve your profitability (as measured by the
profit margin) by reducing the sales of your worst-performing business. However, like any
change in strategy, his plan brings its own risks. One danger, for example, is that you are unable
to find a market for the new as-is apples that used to go into your apple butter. The banker may
neglect to tell you about this and other risks, because he is incented to make you accept his
advice.

Imagine now that you take the banker's advice. In this case, the banker may wait five years to
contact you again, then approach you with a new strategic pitch:
 Your current business is awfully risky, inasmuch as it relies on just one product (as-is
apples). Also, all your revenue from the apples is realized over one or two months per year,
after you have already invested much time and money in the crop. One premature ice storm
could ruin most of your harvest, resulting in a big loss for the year.
 Your business would clearly benefit by diversifying its product base and by generating sales
throughout the year. Diversifying would reduce potential act-of-nature damage, and sales
made during the spring and summer would help meet the costs of maintaining your orchards
and tending your apple trees.
 He knows just the thing to get you diversified and to spread your revenue throughout the
year – an apple butter business!
 He also just happens to know of a small apple-butter business that your could purchase at a
reasonable price, plus an only-nominally-outrageous commission for the banker himself.

Its a sad truth about investment banking that bankers are generally incented to earn fees and
commissions by “doing deals,” whether or not the deal is in the best interest of their clients. A
good, nuanced, real-world example is the case of Dragon Systems' sale to Lernout & Hauspie in
2000. Reporting on the case is available here: "Goldman Sachs and the $580 Million Black
Hole" and at many other places via Google or Bing searches.

COGS Margin
Lets continue working our way through the most common Margin Ratios, starting with the
COGS Margin, and its cousin the Gross Margin Ratio. The two ratios are defined as follows:
COGS Margin ≡ COGS / Sales
Gross Margin ≡ (Sales - COGS) / Sales
Both ratios only apply to industrial entities, and are usually expressed as percentages. I
emphasize the COGS Margin, because of its simplicity, directness, and consistency with other
common Margin Ratios. Note that:
COGS Margin + Gross Margin = 100%

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 11

The COGS Margin measures how much of an entity's sales are eaten up by the cost of its
inventory. In this case, smaller is better. By looking at the ratio for several consecutive periods,
it also tells us if an entity's purchasing and plant-operations are getting more or less efficient.
Similarly, by comparing the COGS Margin to one or more comps, it shows us how efficient an
entity is relative to an individual competitor or its industry. Finally, the COGS Margin estimates
an entity's variable costs. Variable costs are those that scale quickly in proportion to sales.
COGS is a good measure of variable costs because the more an industrial entity sells, the more
inventory it needs and the more COGS Expense it generates.

SGA Margin
The SGA Margin (Selling, General and Administrative Expense Margin) is defined as:
SGA Margin ≡ SGA / Sales (Expressed as %)
SGA Margin measures how much of an entity's Revenue is eaten up by its SGA Expenses. Like
the COGS Margin, smaller is better. If we review the ratio over time or in comparison to comps
we find, respectively:
 If selling and administrative costs are increasing or decreasing, relative to the growth of the
firm overall.
 How an entity's selling and admin costs stack up next to a comparable or to its industry's
average.
The ratio also provides a reasonable guesstimate of a firm's fixed costs relative to its sales. Fixed
costs, unlike variable costs, don't scale quickly in proportion to sales. An example is costs for a
company's HR department, accounting department, and executive suite. If the firm's sales slow,
it would be hard fire significant segments of these departments, because their functions would
remain undiminished (over the short term) despite a drop in revenue. Likewise, a well run firm
should not have to expand these departments in lockstep with sales increases.

This said, the SGA Margin is not a perfect measure of fixed costs, for two reasons. First, it
includes some variable costs, such as advertising. If sales drop, its quick and easy to cut back on
this expense. Second, some important fixed costs are not included in SGA, such as for example
Interest Expense. Interest cost is a function of how much debt a firm has outstanding and the
rate it pays on this borrowed cash. Debt levels are typically set for longish periods and are not
adjusted quickly to a company's sales.

The imperfectness of SGA Margin as a measure of fixed costs is typical of many ratios. In
general, ratios are not flawless measuring tools, and they often work better in some industries
than others. Also, as we saw with the COGS Margin Ratio, some ratios are only applicable to
certain types of entities – Industrial, Service or Financial.

Interest Margin
The Interest Margin Ratio is established as:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 12

 Interest Margin ≡ Interest Expense / Revenue (Expressed as %)
As with any Margin Ratio with an expense in the numerator and sales in the denominator,
smaller is better.

The Interest Margin tells us how much of our sales we have to pay as debt service to our lenders.
This ratio is a rough measure of a firm's riskiness, with increasing Interest Margin equating to
higher risk. It works like this: the more interest a firm must pay the less cash it has to meet other
necessary expenditures.

As usual, viewing this ratio over time or in comparison to comps provides some good insights.
By looking over time we can see if an entity is getting riskier. By comparing to one or more
comps, we can benchmark an entity's riskiness relative to a competitor or to its industry average.

Effective Tax Rate

An entity's is Effective Tax Rate is computed as:
Effective Tax Rate ≡ Tax Expense/Earnings Before Tax (Expressed as %)
= Tax Expense / EBT
This is one of the few Margin Ratios that does not feature Revenue in the Denominator. Tax
Expense typically includes income taxes and short term capital gains taxes, but not real estate
taxes and fees. The ratio does not apply to Limited Liability Companies (LLCs), Real Estate
Investment Trusts (REITs) and other entities that do not pay income tax.

Smaller is generally better (unless you are wildly patriotic). The ratio tells us how much of a
firm's pre-tax income goes to the government. By looking over over time and in comparison to
other companies, this ratio may be used to benchmark an entity's tax efficiency against its
history, a single competitor, or its industry average.

MARGIN RATIOS EXAMPLE – UNITED VS SOUTHWEST AIRLINES

Consider the following Margin Ratio data for UAL and LUV5. Lets use this info to ask and
answer some interesting questions about the competitors.

5 Reminder: All of UAL's financial statements used to prepare this table and the remaining ratio tables in this
chapter are located in the chapter's appendix.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 13

Questions:
1. During last year:
 Who had better profitability on average? Why?
 Who was more consistently profitable?
2. What can you say about COGS trend for each company? Why?

Solutions:
1. “During the last year” suggests that we should be looking at Q1 through Q4 ratios.
“On Average” implies that we should be looking at TTM figures.
Profitability is measured by the Profit Margin Ratio. Comparing the TTM numbers for UAL
and LUV we see that LUV is far more profitable on average, with a TTM profit margin of
6.00% vs UAL's measly 0.84%.
Looking quarter by quarter, we see that LUV was also more consistently profitable. Though
both firm's profits were volatile (partly because of their seasonality), UAL's profit margin
was negative for three of the four latest quarters, while LUV was always profitable.
2. For COGS trends, we should review all eight available quarters, looking year-over-year.
UAL's COGS Ratio held steady for Q8 to Q4 and Q7 to Q3, but started to jump up in Q6 to
Q2 and Q5 to Q1 (79.1% to 83.8%, and 75.8% to 83.7% respectively).
LUV's COGS ratio has started to increase over the same period, rising from 74.7% in Q6 to
75.3% in Q2, and from 67.9% in Q5 to 73.9% in Q1.
In both cases, the increase is largely due to spiking jet fuel prices.

3. EFFICIENCY AND TURNOVER RATIOS

Our third class of financial statement ratios is comprised of Efficiency and Turnover Ratios.
Efficiency Ratios are defined as:
Efficiency Ratio ≡ (An Income Statement or Cash Flow Statement Term)
(A Balance Sheet Term)
Turnover Ratios are similar, but with the numerators and denominators switched:
Turnover Ratio ≡ (A Balance Sheet Term)
(An Income Statement or Cash Flow Statement Term)

Efficiency Ratios tell us, for example, how quickly an entity converts assets into sales or cash
flow, and related metrics. Turnover Ratios measure things like how much sales or earnings a
firm's assets generate. Lets look at some of the most common Efficiency and Turnover Ratios.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 14

Asset Efficiency Ratio
We looked briefly at the Asset Efficiency Ratio earlier in this chapter. Recall that it is computed
as:
Asset ≡ Sales (AER, typically expressed as %)
Efficiency Assets(BOP)
As we noted previously, the Asset Efficiency Ratio measures the amount of sales company
generates from each dollar of its assets, during an accounting period or periods. It is most
applicable to industrial entities, which may use large amounts of PPE and other assets to create
inventory. Like virtually all ratios, it is helpful for benchmarking an entity relative to its history
(by looking at the entity's ratio over multiple periods), and to its industry or to a single comp (by
comparing the entity's ratios with the comps').

Bigger is usually better for this ratio, but not always. In general, entities should try to sell as
much as possible utilizing as few resources as possible. However this can go too far. Consider
Vermont Organic Apples again. Say the owner notices that of his two tractors, only one is
needed about 90% of the time. He figures that, by working his first tractor a bit harder, he can
sell the second one – and enjoy a one-time, sale-price cash flow as well as ongoing savings in
maintenance and repair costs. The fatal flaw with this analysis is that, if the owner's single
tractor fails during the apple harvest season, he may loose much of his crop because he can't
transport it. The lesson is that entities should be as “lean” as possible without significantly
jeopardizing their ability to operate.

Almost every time we say that “bigger is better” or “smaller is better” for a given ratio, this
claim needs to be qualified and not taken to extremes. Going forward I'll assume we all
understand this, and will stop describing the particular qualifications for most individual ratios.

Unlike the case for Sales Growth Ratios and Margin Ratios, we have to be careful with the units
of Efficiency and Turnover Ratios. Notice that Turnover Ratios carry units of
(Dollars) / (Dollars per period), and the units for Efficiency Ratios are the inverse of this. To
ensure that we make apples-to-apples comparisons of these ratios, we will usually choose units of
(Dollars) / (Dollars per Year) or the inverse of this. So, for example, an annual Asset Efficiency
Ratio will be computed like this:
Asset Efficiency Year 20X0 = (Sales) For the Year 20X0 / (Total Assets) BOP 20X0
with units (Dollars per year) / (Dollars). The ratio for the third quarter of the year will be
computed as:
Asset Efficiency Q3 = 4*(Sales) For Q3 / (Total Assets) BOP Q3
Multiplying the Q3 sales by four converts the units from Sales per year to Sales per quarter.
After converting, we can directly compare the Year 20X0 ratio with the Q3 ratio, as they now
carry the same units.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 15

Return on Assets
Return on Assets is defined as:
Return on Assets ≡ Net Income / Assets(bop) (ROA, expressed as %)
ROA is the income an entity produces for its owners during a period, using the assets it had to
work with at the beginning of the period. Like Asset Efficiency, it is most useful for industrial
companies, and bigger is often better.

An imperfection of ROA is that Net Income measures returns only to an entity's owners, but the
firm's assets have been funded by owners, lenders, and profitable business operations. For this
reason, some analysts, executives and managers prefer the ratio EBIT/Assets to AER. EBIT
stands for Earnings Before Interest and Tax, and it represents income available to lenders and
owners.

Return on Equity
Return on Equity, or ROE is computed as:
Return on Equity ≡ Net Income / Equity(bop) (ROE, expressed as %)
ROE measures how much income an entity generates for its owners, relative to the firm's equity
at the beginning of the period. Bigger is better. This ratio is useful for all types of entities –
Industrial, Service and Financial – and is arguably the most common financial-statement ratio
used by managers and equity investors.

Good to Know
Most analysts and managers are happiest when ROE is positive, large, and growing. This said,
for big companies in most industries, an ROE between about 8% and 20% is pretty good. The
cap of 20% comes from competition. If smart businesses see a company earning an ROE of, say,
50% or more, they will be temped to enter the business themselves. This added competition will
typically drive down prices (and therefore Revenue), and lower ROE for everyone.

Since bigger is better for ROE, it can be improved by increasing its numerator (Net Income) or
decreasing its denominator (equity). Increasing Net Income would typically be done through an
operational plan, such as by reducing costs without impairing sales. Decreasing equity is
typically a long-term, financing-strategy decision. Equity can be reduced in a number of ways,
including for example:
 A leveraged buyout, which would exchange equity for debt.
 Using a firm's cash generated by operations to repurchase and retire some of its equity
shares.
We will learn more about the importance of equity to ROE later in this chapter, when we look at
Leverage Ratios.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 16

EXAMPLE: COMPUTING UAL'S ROE
Lets take a minute out to be sure you understand how to compute ROE, and by extension, other
Efficiency and Turnover Ratios. Consider this information taken from UAL's financial
statements, as listed in Appendix to this chapter).

Balance Sheet

Income Statement

UAL's TTM (annual) ROE is computed as follows:

ROETTM: = NITTM / EquityBOP = 126 / 950 = 13.3%
Where EquityBOP measures equity at the beginning of the twelve month period, or at the end of
Q5. The units used are (Dollars per Year) / Dollars.

UAL's Q1 ROE is computed as:

ROEQ1: = 4* NIQ1 / EquityBOP = 4 * (-3 / 1,471) = -0.8%
Where EquityBOP measures equity at the beginning of Q1, or the end of Q2. The units used of
Dollars per Quarter are multiplied by four to convert them to Dollars per Year units.

Fixed Asset Efficiency (FAE)

The FAE Ratio is:
Fixed Asset Efficiency ≡ Revenue / Net PPE(bop) (FAE, expressed as %)
FAE Ratio measures how much Revenue (sales) a firm generates in a period from the net PPE
available at the beginning of the period. It is useful for understanding heavy industrial entities,
like car manufactures, that use a lot of PPE to create inventory. It is also a good ratio for firms
that generate sales directly from their PPE, such as REITs (which generate Revenue by leasing
the space in their buildings) and utilities (that sell the electricity generated by their power plants).

FAE is usually described with “times,” percent, or no modifier. For example, an entity may say
“our sales are 2.7 times our fixed assets,” “our sales are running at 270% of our fixed assets,” or
“our FAE is 2.7”

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 17

Inventory Efficiency (Inv-E)
This ratio measures how much inventory a firm matches to its sales in a period.6 It is defined as:
Inventory Efficiency ≡ (COGS) / Inventory(bop) (Inv-E, expressed as %)
The ratio only applies to Industrial entities, and bigger is better.

Accounts Receivable Turnover (AR-T)

AR-T is defined as:
Accounts Receivable Turnover ≡ Accounts Receivable (EOP) / (Sales made on credit)
This ratio aims to measure how much of a company's credit sales remain uncollected at the end
of an accounting period.
In this case smaller is better. This is because of a general rule in finance: within reason, its
always better to receive cash as soon as possible, and to delay dispensing cash for as long as
possible. So, at the end of an accounting period, firms ideally want to have received cash for
every sale made in the period.

Clearly, this ratio only applies to firms who make most of their sales on credit7, as opposed to
those collecting cash at the time of sale. Unfortunately, most entities do not report how much of
their sales are made on credit. For this reason, AR-T is often computed as:
AR-T ~ Accounts Receivable(EOP) / (Revenue) = AR (EOP) / (Revenue)
where “~” means “is approximately equal to,” as used throughout this text. The approximation is
good for firms that make most of their sales on credit.

AR-T is described using percent, years, or days, as follows:

 “At EOQ-3, our Accounts Receivable is running at 27% of annualized sales.”
 “At EOQ-3, our AR-T is 0.27 years.”
 “At EOQ-3, our AR-T is 99 days.”
(Where we converted from “years” to “days” by multiplying by 365. 99 = 0.27*365).

Accounts Payable Turnover (AP-T)

The Accounts Payable Turnover Ratio is really a liability Turnover Ratio. It is defined as:
Accounts Payable Turnover Ratio
≡ Accounts Payable(EOP) / Inventory Purchases in the Period. 22h)
This ratio is a corollary to the AR-T Ratio. It aims to measure how much of a company's
inventory purchases were paid for during a period. For the AP-T Ratio, bigger is better, because

6 Recall that COGS represents the amount of inventory sold in a period, as measured by the lower of cost or
market.
7 IE: firms that invoice most of their sales, or allow customers to pay with credit cards, etc.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 18

a firm with a big ratio is making payments later (and holding onto cash longer) than a company
with a smaller ratio. This ratio is described using percent, years, or days.

Inventory purchases are not reported directly by most companies, but may be computed as
follows:
Let “I” stand for Inventory. Then for a given accounting period:
IBOP + (Purchases of I) – COGS = IEOP, where we assume no write-downs.
Re-arranging terms, we get:
(Purchases of I) = COGS + ΔI, where ΔI = IEOP – IBOP.

For computational simplicity, the AR-T ratio is often approximated by:

AP-T ~ Accounts Payable(EOP) / COGS 22k)
The approximation works well when COGS is a fairly decent proxy of inventory purchases. This
is the case for large, non-seasonal, steady-state firms (like Proctor and Gamble for example).
Here is how we justify the approximation for this type of entity:
Recall from above: (Purchases of I) = COGS + ΔI
For large, non-seasonal, steady-state firms, ΔI is typically close to zero. Setting ΔI to zero in this
equation yields:
(Purchases of I) ~ COGS
Substituting COGS for Inventory Purchases in equation 22h) yields the approximate AP-T
relation 22k). For convenience, we will use the approximate ratio in this chapter (even though it
does not perfectly fit UAL and LUV, which are seasonal companies).

Good to Know
Notice that, in general, the more approximations we make to our ratios, the more specialized
their usage becomes. This is an important insight not just for ratios, but for all mathematical
models in finance. Many big mistakes in finance are down to the use of models in situations
where they do not apply. Understanding the simplifying approximations and assumptions of all
financial models is an absolute prerequisite to using them with confidence.

Cash Level (CL)

Cash Level is defined as:
Cash Level ≡ (Cash + Cash Equivalents)EOP / Revenue (CL, expressed as %)
Cash Level measures what percent of a company's annualized sales it is holding in cash.

CL is often used to see if an individual company's cash balance is safe, when compared to the
average level of its comps. Here are some appropriate ballpark cash levels for entities in several
industries:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 19

 Typical Cash Levels Needed for Safe Running of Business
Company Type Sales Minimum Safe CL
Manufacturing Big 2% - 4%
Technology Big 4% - 20%
Start-up Small 20% - 200%

These ranges are imperfect, because a company may have ready sources of cash (or ready
sources of “liquidity”) that do not appear in its Cash Level Ratio. For example, a firm may have
a “Revolving Loan” agreement with a bank for $20MM. The loan allows the company to borrow
up to $20MM at any time. (This works like a credit-card loan).

Companies with revolving loans effectively have bigger cash reserves than reported by their their
CL Ratios. For this reason, many analysts compute “Cash and Liquidity” Ratios, which include
cash available in revolvers. The amount available through loans is not reported on an entity's
financial statements, and must be manually dug out of its SEC 10-K filings.

CL is also used to see if an entity is holding too much cash. Equity investors usually don't like a
firm to hold more cash than it needs. This is because the company earns a very low return on its
cash pile, and investors feel they could do better themselves. So when a company has extra cash,
equity investors would like the firm to transfer this excess to them in the form of dividends.

Debt investors, by contrast, get warm fuzzy feelings when a company has a good stockpile.
They like this because it increases the probability that their loan or bonds will be repaid on-time
and in-full. As a result debt holders are often unhappy about a company's issuing dividends to
shareholders, and will often write restrictions on this practice into their loan and bond contracts.

EXAMPLE:
EFFICIENCY AND TURNOVER RATIOS FOR UAL AND LUV
Consider these ratios for UAL and LUV, and answer the questions below.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 20

1. During the past year, on average, who gets the most sales from their assets?
Does this make sense? Has this been more-or-less consistently true for past two years?

From the TTM AER Ratios, we see that UAL gets the most revenue per dollar of asset. This
makes sense because UAL is a full service provider, with first-class, business and economy
sales. LUV only offers low-cost, economy class seats. UAL has earned more than LUV per
dollar of assets for the past seven quarters.

2. Over the past year, on average, who has received the most income from their assets?
How do you explain this, given your answer to 1) above?

LUV, based on TTM ROA Ratios. Given UAL's higher AER, LUV's higher ROA must be
derived from a significantly lower cost structure.

3. On average over the past year, who provides owners with the most income per dollar of
equity investment? How does your answer change when you look over the past four
quarters individually. What does this tell you about looking at only TTM Ratios?

UAL's TTM ROE is much higher than LUV's. On inspecting quarter-by-quarter, we see this
is because UAL had a huge ROE in Q4, despite generating negative ROE for Q's 1 to 3. By
contrast, LUV's ROE has been positive for the past four quarters. All this tells us that it is
not enough to look exclusively at annual ratios, especially for seasonal companies
experiencing volatility in sales. Quarterly and/or monthly ratios should be reviewed as well.

4. On average, who has managed their receivables (AR) best over the past year?
Has this been consistently true for past two years?

LUV has done better than UAL during the TTM period, as evidenced by its smaller AR-T
Ratio. LUV has also done better in each of the past eight quarters.

5. On average, who has managed their payables (AP) best during the past year?
Has this been ~ consistently true for past 2 yrs?

Once again, LUV has done better than UAL during the TTM period, as evidenced by its
larger AP-T Ratio. LUV has also done better in six of the past eight quarters.

6. Assuming no impending mergers etc., who has managed cash best over the past year? Why?
What inside information from LUV might change your opinion?

Based on the specified criteria, UAL has done a better job, because LUV has clearly been
hanging onto excess cash. In fact, LUV has been accumulating cash over the past two years.
If it has been saving up to buy a distressed competitor during a down-market time, this
might have been a smart and proper move.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 21

EXAMPLE: USING CASH LEVEL AND ROE TO HELP IDENTIFY AN ANTI-
TRUST LAW VIOLATOR
Ratio Analysis is not just for managers and investors. Lets see how the U.S. Department of
Justice (DOJ) could have used it to help identify Microsoft (MSFT) as anti-trust law violator in
the late 1990s.

First, as usual, here is a little background. In the U.S., an anti-trust violator must exemplify two
characteristics:
1. It must be a monopolist.
2. It must use its monopoly to protect and extend it's monopoly, and to undermine customer
choice.

In the mid 1900's, many computer makers and Netscape Inc. (an Internet browser company)8
complained to the DOJ that MSFT was unfairly requiring PC makers to promote MSFT's Internet
Explorer browser in order to purchase the Windows 95 operating system. Based on these
assertions, the DOJ filed an anti-trust suit against MSFT in 1997. The DOJ argued that computer
makers had no alternative to installing the Windows 95 operating system (OS) on their machines,
because it was the only OS in common commercial use. Therefore, the DOJ further argued,
MSFT's insistence on the promotion of Internet Explorer was an obvious unfair extension of its
monopoly, aimed at killing Netscape and undermining customer choice.

Part of MSFT’s defense was to claim that it did not have a monopoly on personal computer
operating systems. It pointed to IBM's OS/2 and Linux as alternatives. As the DOJ knew from
its own research, these were weak defenses. OS/2 was probably IBM's most spectacular
software failure of all time. Despite a huge effort by the company, OS/2 never caught on with
consumers or small businesses, and was formally dropped in 2001. Similarly, in 1997 Linux was
virtually unknown to PC users, and in 2013 it still claims only about 2% of the desktop PC OS
market.9

The DOJ's case against MSFT could be further bolstered with a bit of Ratio Analysis. Here is
how it could work:
 First note that the DOJ needed only prove that Windows 95 was a monopoly OS. If this was
true, then MSFT's required bundling of Internet Explorer with Windows 95 clearly made
MSFT an anti-trust violator (as the DOJ claimed).

 Next note that, in general, only a monopolist can enjoy extraordinarily great financial
performance, as measured by ROE or other metrics. This is because a product's high ROEs
will drive competitors to market similar offerings – especially in the hyper-competitive
8 The Netscape browser was the first widely-available Internet surfing tool. It radically simplified access to the
Internet, and opened up the network to non specialist users for the first time. Netscape was invented by Marc
Andresson, who is now a partner at Andresson Horowitz, one of Silicon Valley's most prominent and successful
venture capital funds.
9 http://www.netmarketshare.com/operating-system-market-share.aspx?qprid=10&qpcustomd=0

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 22

 technology industry. The emergence of new products drives down prices, and lowers
everyone's ROEs to more normative levels. The only way to prevent this chain of events is
with a monopoly or some other barrier to competitors' entry.

 Finally, analyze MSFT's revenue and ROE. In 1997, although MSFT enjoyed large sales
from its office suite of products, the lion's share of its revenue came from sales of its
operating system software (Windows 3.1 and Windows 95). So, if the company's ROE was
extremely high and much higher than competitors, this would be prima-face evidence of the
company being an OS monopolist.

Performing a 1997 ROE study of large, successful software technology firms (excluding MSFT)
we find ROEs mostly grouped between 15% and 25%.10 Microsoft's ROE at the time is
computed as follows:

At 57%, MSFT's ROE is pretty high compared to similar software companies of the time. Even
so, this number is actually depressed. Note that the firm has $23BB in cash, which is about 1/3 of
its total assets and 39% of its annual revenue (IE: a 39% Cash Level Ratio). This seems awfully
large, so lets compare it to the cash levels of our large, successful software firms. Computing the
cash levels for these firms shows that they are on the order of 3% to 10%.

10 Presented without backup in order to keep the size of this example manageable.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 23

Lets see how MSFT's 1997 ROE looks if the firm is holding a more reasonable amount of cash,
say 5% of sales ($3,021 MM). To get to this level of cash, we could envision MSFT giving its
shareholders a dividend of $20,390 MM as follows:

As shown, the cash dividend of $20,390 MM would reduce MSFT's equity by the same
amount.11 This in turn would reduce the denominator of MSFT's ROE Ratio. With the firm
holding this more reasonable level of cash, we compute MSFT's ROE Ratio as a whopping
154%! This is so high because the firm earns a very small return on its cash as compared to its
other assets. By removing the drag on ROE caused by MSFT's excess cash, we measure the
ROE generated by just the firm's business operations.

Based on our analysis of industry comps, MSFT's 154% ROE is a clear indicator that its OS
software is a monopoly product. If it were possible for other firms to compete with Windows 95,
they certainly would, in order to enjoy an ROE closer to 154% than the software industry range
of 15% to 25%. This analysis would nicely complement the DOJ's market-share study of
Windows 95 vs competing offerings such as OS/2 and Linux.

Postscript:

11 The journal entries for this are:

cr Cash $20,390 (A)
dr Dividend $20,390 (E)

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 24

Microsoft was found to be in violation of antitrust laws, and was required to let PC makers
endorse whatever internet browser they chose. This was too late for Netscape, whose browser
slid into oblivion. The DOJ's efforts also did not hinder MSFT, which continued its hegemony in
OS software until the rise of the smart-phone and the tablet, which run today primarily on
Google's Android (a variant of Linux) and Apple's iOS.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 25

4. FINANCIAL AND OPERATING LEVERAGE
RATIOS
Here is a reminder of our five classes of ratios
1. Revenue and Revenue Growth Ratios.
2. Margin Ratios.
3. Efficiency (Turnover) Ratios.
4. Financial and Operating Leverage Ratios.
5. Liquidity Ratios.

Lets continue our review with a look at Financial and Operating Leverage Ratios. Financial
Leverage measures an entity's debt financing relative to some or all of its total financing. It is
also described as a measure of debt relative to income or cash flow. In short:
Financial Leverage ≡
§ Debt Financing / Equity Financing (%), or
§ Debt Financing / Total Financing (%), or
§ Debt / Measure of income or cash flow (Years).

Operating Leverage measures a firm's fixed costs relative to its variable costs. IE:
Operating Leverage ≡ Fixed Costs / Variable Costs
As noted earlier in this chapter, fixed costs are expenditures that do not scale with small or
medium changes in sales. An example for UAL would be the lease payment on one of its jets.
The payment remains constant if the plane is running at full capacity or half of that. Variable
costs are expenditures that scale almost linearly with small or medium changes in revenue.
UAL's variable costs include the amount if pays caterers for its on-board meal services. The
amount provided and paid for changes directly with the number of passengers flows, and the
revenue received from them.

In the limit, all costs are variable. UAL for example can cancel plane leases (by paying a
penalty) and lease more planes as passengers-flown decreases or increases, respectively. To
avoid confusion, we will define fixed costs to be any expenditure that a company can not adjust
easily in one quarter of operations; we likewise define variable costs as items that can move in
sync with revenues during a single quarter.

The key property of Financial and Operating Leverage is that increasing either of them will
improve a firm's financial performance in good times (when revenues are stable or rising and
costs are stable or declining), and decreasing them will impair an entity's performance. Financial
and Operating Leverage Ratios are typically set up so that large values imply high levels of
leverage. Accordingly large values indicate upside potential in good times, and increased
bankruptcy risk in bad times.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 26

A. FINANCIAL LEVERAGE
Financial Leverage Ratios are popular among analysts and potential investors, in part because the
data needed to compute them is easy to find in financial statements. The data required for some
Operating Leverage Ratios is not recorded on financial statements, and is therefore of more use
to company managers and executives.

Debt to Assets Ratio

The Debt to Assets Ratio (DtA ratio) is defined as:
Debt to Assets Ratio ≡ Total Debt (long and short term) / Total Assets (DtA expressed as %)
DtA measures how much of an entity's total assets (measured at cost or cost minus wear) were
financed with debt. A large number implies a high level of debt financing. As with all Leverage
Ratios, bigger numbers indicate more potential upside for owners in good times, and more
bankruptcy risk in bad times.

DtA is a useful measure for any type of firm, but especially for industrial and financial entities.
As usual, the appropriate size of the ratio varies by industry and other factors. A regulated utility,
for example, can safely enjoy a large DtA Ratio, as its operates as a monopoly with revenues that
are more-or-less guaranteed. A technology start-up, by contrast, should maintain a low DtA
Ratio, as its revenues are subject to relatively wild swings.

Self-Testing Questions
1. Can an entity's DtA Ratio be greater than 100%? Why or why not? 2. What is a lower bound
on the DtA ratio? Why? 3. What is an upper bound? Why?

Solution
1. Yes. This means the company has negative equity. (Recall Equity ≡ Assets – Liabilities).
2. Lower bound is zero, corresponding to an entity with no debt.
3. Upper bound theoretically can approach infinity, for a company with a huge amount of debt.
In practice, companies go bankrupt when their debt is so large that they cannot pay interest
on it or refinance it.

Good to Know
Its very helpful to perform an analysis similar the one above for all the ratios. Understanding:
 Ratios ranges,
 The implications of being near the end of a range, and
 The implications of being at a key point in a range is good ammunition for analyzing any
firm.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 27

EXAMPLE:
FINANCIAL LEVERAGE AND PRIVATE EQUITY INVESTORS
Now that we understand what financial leverage is and one way to measure it, lets see how it can
be used and explore its effects.

Consider two sets of investors – the Conservatives and the Cowboys – that are contemplating the
purchase of ToolCo, Inc. ToolCo supplies specialty tools to motorcycle mechanics. The firm has
$100MM in assets (in both market-value and GAAP terms) and no debt. Its owners are willing
to sell for $100MM.

The Conservatives aim to pool their funds and purchase the firm for $100MM cash. The
Cowboys plan to pay the same amount, sourced by using $10MM of their own funds, and
$90MM from a loan taken out by ToolCo itself. (The loan is pre-arranged to be taken out as
soon as the Cowboys take ownership of the firm. The proceeds of the loan are immediately
delivered to the prior owners of ToolCo. The loan's interest rate is 10%, and lets say that it was
made by JP Morgan). After purchasing ToolCo, the firm's Balance Sheet looks like this, for the
Conservatives and the Cowboys:

Notice that the firm's assets are the same no matter who buys it. The differences in debt and
equity are down to the contrasting methods used to finance the purchase of the firm. The DtA
Ratio for the Conservatives-funded firm is 0%, while the Ratio for the Cowboy-funded version is
a hefty 90%.

Now consider the firm's Income Statement and ROE Ratio for its first year of operations under
the new management, again for both the Conservatives and the Cowboys. Assuming this is a
good year, the ISs and ratios look as follows:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 28

Note that the Conservatives enjoy more Net Income from ToolCo ($15MM vs $8.25MM for the
Cowboys). However, the Cowboys return on their equity investment ($10MM), as measured by
ROE, is much higher than the return that the Conservatives realize on their $100MM (82.5% vs
15.0% respectively). This is because the Cowboys achieved NI of $8.25MM after investing just
$10MM (and paying J.P. Morgan loan interest of $9MM).
$8.25 / $10.00 = 82.5% ROE.
The Conservatives, by contrast, paid no interest and achieved NI of $15MM, but they invested
10 times more than the Cowboys to achieve this result.
$15 / $100 = 15% ROE.

Based on what we've seen so far, it seems like the Cowboys have the best investment strategy by
far. But consider how things would look if ToolCo experienced a bad year after being purchased.
Specifically, consider how things would look if ToolCo realized revenue of $30MM instead of
$50MM:

Even with a drop in revenue of 40%, the Conservative-funded version of ToolCo enjoys positive
Net Income and ROE ($3.75MM and 3.8%). By contrast, the Cowboy-funded incarnation of

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 29

ToolCo looses $3MM during the year; if these losses were to continue, ToolCo would run out of
cash and be forced into bankruptcy.

The moral of this story is, as asserted above, increased leverage increases financial performance
in good times, but increases bankruptcy risk in bad times. In this case the Conservatives will
probably get a lower return on their investment than the Cowboys under most circumstances, but
they will enjoy a much smaller probability of “flaming out” if things go badly for ToolCo.

As you've probably guessed, the Cowboys' approach is close to the method that Private Equity
investors use to purchase companies. Although the strategy looks risky, it carries benefits
beyond generating high ROEs during good times. Assuming the Conservatives and Cowboys are
equally “capitalized” (IE: they both have $100MM of their own money to spend), the Cowboys
can buy nine other entities of ToolCo's size. This could give the Cowboys a diversified portfolio
of companies with less overall risk than the Conservatives 'all our eggs in one basket' investment.
Additionally, the Cowboy's risk is reduced by the quick “payback” on their investment. Say that
ToolCo runs well for two years. At the end of this time the Cowboys will have received
$16.5MM in Net Income on their $10MM investment. If ToolCo then has a horrible year and
can't pay the interest payments on its loan, the Cowboys can simply surrender the firm to J.P.
Morgan (the lender), and walk away with a profit of $6.5MM. Of course, in this case the
Cowboys would need to find an alternate lender for their next deal.

Debt to Capitalization Ratio

Before defining the Debt to Capitalization Ratio (DtC), you should know that “capitalization”
refers to a firm's total debt and its equity. IE:
Capitalization ≡ Total Debt + Equity
Capitalization roughly measures how a firm funds its assets.

The DtC Ratio measures a firm's debt relative to it capitalization. Mathematically, the ratio is
defined as:
Debt to Capitalization Ratio ≡ Total Debt (long and short term) / (Total Debt + Equity)
(DtC, expressed as %)
DtC = Total Debt (long and short term) / (Capitalization)

As with the DtA Ratio, a large number implies a high level of debt financing, and bigger
numbers indicate more potential upside for owners in good times, and more bankruptcy risk in
bad times. DtC is a useful measure for any type of firm.

Debt to EBIT Ratio

The Debt to EBIT Ratio (DtEBIT) measures an entity's debt relative to earnings available to pay
down debt. It is defined as:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 30

 Debt to EBIT ≡ Total Debt(EOP) / EBIT (DtEBIT , expressed in years).
As we know, EBIT is short for Earnings Before Interest and Tax, and is the amount of earnings
an entity has available to pay interest, taxes, shareholder dividends, etc.
DtEBIT's units are years. Quarterly EBIT must be annualized (multiplied by four) to maintain
consistent units.

DtEBIT tells us about how many years it would take an entity to amortize (pay off) all its debt, if
all its EBIT could be devoted to this task.

Like most other ratios, DtEBIT is imperfect. In the real world, it is rare for companies to put all
their EBIT toward amortizing debt, because (for example) they have to pay interest on their
outstanding borrowings. Also, unless they are unprofitable they will have to pay some taxes.

B. OPERATING LEVERAGE
As noted above, Operating Leverage measures an entity's fixed costs relative to its variable costs.
Also, we will consider fixed costs as expenditures that cannot be easily adjusted during one
quarter of operations. We likewise define variable costs as those that may move in sync with
revenues during a quarter.

Operating Leverage is similar to Financial Leverage, in the sense that higher levels of either one
may produce better financial performance in good times but increase bankruptcy risk in bad
times. So, as you may suspect, the two types of leverage are not completely independent.
Interest Expense, for example, is related to Financial Leverage, but it is also a fixed cost. To get
a feel for how Operating Leverage works and how it differs from Financial Leverage, lets look at
an example.

OPERATING LEVERAGE EXAMPLE: WEA VS CARPENTER

Lets compare and contrast the investment management business of West End Advisors (WEA)
with a carpenter's operations. Here are BOY Balance Sheets and two sets of annual Income
Statements for both firms:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 31

Note that:
 The firms start the year with identical, debt-free Balance Sheets. The absence of debt will
ensure that performance differences will not be influenced by Financial Leverage.
 WEA has no variable costs. It must pay its rent, employees, etc irrespective of how much
money it manages.
 The carpenter has fixed and variable costs. Rent on her shop, for example, is a fixed cost
while her diesel fuel expenses will vary with the number of jobs she takes on and her
revenue.

Looking at each firm's Income Statement for a “Good Year,” we further see that revenues, total
expenses, Net Income and ROE are the same for both firms. However, WEA's ratio of fixed
costs to total costs is 100%, while the carpenter's is just 50%.

The “Bad Year” ISs show a divergence in the two firms performance. Although revenue is the
same for each firm ($25K), WEA's fixed costs have not declined. As a result, its Net Income is
cut quite drastically (from $22.5K to $3.75K), and its ROE is accordingly depressed (dropping
from 22.5% to 3.75%). By contrast, the carpenter's Net Income only dropped to $7.5K, and her
ROE only dropped to 7.5%). She outperformed WEA because she scaled back her variable costs
in proportion to her dropping revenue. Because she could not reduce her fixed costs ($10K), her
ratio of fixed to variable costs has climbed from 50.0% to 66.7%. WEA's fixed/variable cost
ratio of course remains at 100%.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 32

WEA's high fixed cost structure clearly hurts it when times are tough. In good times, the same
structure will help it outperform the carpenter, as shown in these “Very Good Year” annual
Income Statements:

In this case WEA outperforms, as seen in its 41.3% ROE vs. the carpenter's 37.5%. WEA does
better because its costs do not increase, even as its revenue climbs from $50K to $75K. The
carpenter's variable costs move up with her increased sales, which holds down her Net Income
and her ROE. Here WEA's fixed/variable cost ratio remains at 100%, while the carpenter's has
declined to 40%.

Finally, its interesting to consider a scenario where market conditions for WEA and the carpenter
get better and better. In this situation, WEA's revenues can grow indefinitely, and the firm will
enjoy ever improving ROE. By contrast, the carpenter’s revenues, profits and ROE will stall.
Why? At some point, the carpenter will book all her working hours and have to turn down
additional jobs and revenue. (In this case we ignore her possibly hiring another worker, which
would fundamentally alter the financial structure of her business). On the other hand, WEA's
work is almost the same for managing small amounts of money as for large amounts. This is
especially true if increases in funds-to-manage come from the firm's existing customers.

Entities like WEA are said to have “high fixed cost” business models that “scale efficiently.”
High fixed cost, efficient scaling businesses are sought after by savvy entrepreneurs and Venture
Capitalists alike, because they ensure the possibility of unhindered growth and increasing
profitability.

Measuring Operating Leverage

In the above example, WEA and the carpenter had conveniently separated their costs into fixed
and variable categories. GAAP accounting does not require that firms provide this breakdown.
As a result, most firms to not publish this information with their financial statements or

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 33

anywhere else that outsiders can access. (This is partly because of the work involved and partly
because publishing it would unnecessarily give competitors useful information).

For analysts and investors who must rely exclusively on firms' financial statements for Ratio
Analysis, fixed to variable cost ratios (Operating Leverage Ratios) are approximated using
GAAP-based information. Our next ratio is a good example.

SDI to COGS Ratio (SDItC)

The SDI to COGS Ratio (SDItC) approximately measures an entity's fixed costs relative to its
variable costs. “SDI” stands for SGA, Depreciation and Interest expenses. Mathematically, the
ratio looks like this:
SDI to COGS ≡ (SGA + Depreciation + Interest) / COGS (SDItC, expressed as %)

SGA, Depreciation and Interest are proxies for the entity's fixed costs. Depreciation and interest
are better proxies than SGA. Clearly, interest payments and depreciation will not scale quickly
with sales. Much of SGA, such as accounting department salaries and headquarters rent, also
does not move in sync with sales. However, some pieces of this expense, like advertising, might
closely track revenues.

As we know, COGS tracks sales very closely. The downside of using COGS to track variable
expenses is that it makes this ratio useless for service and financial firms, which have no
inventory. As a result, the SDItC Ratio is only useful for industrial entities.

EXAMPLE:
LEVERAGE RATIOS FOR UAL AND LUV
Consider these ratios for UAL and LUV, and answer the following questions.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 34

1. Looking at the past year, which firm has the higher level of debt financing?

To answer this question, we could use either the Debt to Assets Ratio or the Debt to
Capitalization Ratio. Choosing the DtC Ratio, we see in the TTM column that UAL is much
more levered than LUV. (Cal has a 77.2% DtC Ratio, vs 23.4% for LUV).

2. Which firm has the higher Operating Leverage

How do you reconcile this with your answer to 1) above?

From the two firms' SDItCOGS Ratios, we see that LUV has more Operating Leverage
(28.2% SDItCOGS for UAL vs 36.2% for LUV). As we know, SDItCOGS is not directly
measuring debt, so this result is entirely possible, irrespective of each firms Financial
Leverage.

3. Based on your answers to 1) and 2) above, and sales trends for both companies for the past
two years, which firm would you rather lend your money to? Why?

Our above analysis tells us that UAL is by far the more financially levered firm, and this fact
swamps the relatively modest differences in Operating Leverage. So UAL is the higher risk,
higher potential reward entity. As seen in the above table, the sales trends for both firms are
good. So the decision as to which firm we would rather lend to comes down to our risk
tolerance. High-risk investors might choose to lend to UAL – demanding a higher interest
rate in exchange for taking on its high bankruptcy risk. Risk averse investors, by contrast,
may choose to lend to LUV, accepting a lower interest rate in exchange for not having to
worry about bankruptcy risk.

4. Looking at the past eight quarters, has one (or more) firm’s financial ‘leverage position’
significantly improved or deteriorated? Explain.

By reviewing each entity's DtC Ratio, we see that UAL has reduced its leverage while LUV
has slightly increased its debt as a percentage of its capitalization. UAL's reduction may be
an attempt by the company to reduce its bankruptcy risk during a period of declining and
negative Net Income (as we saw when doing Margin Analysis of both firms). LUV could be
increasing its leverage for many reasons, but it is probably just aiming to increase its ROE.

5. Based on TTM figures, about how many years would it take for each company to pay off its
debt, if it put all reasonably-possible effort into this task?

Using Debt to EBIT Ratios, we find 11.4 years for UAL, and 2.3 years for LUV.

6. Considering all the Ratio Analysis we have done so far, which firm is riskier? Why?

Overall UAL is clearly the most risky firm, as measured by (among other things) its
erratic/negative profit margin, its Debt to Capitalization, and its Debt to EBIT.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 35

5. LIQUIDITY RATIOS
Liquidity Ratios comprise our final class of Ratio Analysis tools. Before delving into them, lets
clarify what we mean by “liquidity.”

Liquidity is used to mean several things, depending on context and intent. The most general
definition of liquidity is “a measure of firm’s ability to quickly produce cash, to meet (certain
and/or potential) short-term obligations.” Here is an example illustrating this use of the term:
In Q4-2008, Treasury Secretary Henry Paulson outlined the Treasury’s proposal to provide
an unlimited amount of liquidity to Fannie Mae and Freddie Mac. He defended the unlimited
allocation as follows:
"If you've got a squirt gun in your pocket and people know that, you may have to take it out
and use it," he said. "But if you've got a bazooka, you may not have to take it out."

A more specialized definition of liquidity is “the ability to quickly convert an investment

portfolio to cash with little or no loss in value.” This quote from the Wall Street Journal in June
of 2008 shows how the term was used to help describe the fall of Bear Stearns:
“$40BB of Bear Stearns’ portfolio was illiquid – comprised of CDOs and other inscrutable
securities for which no one would bid.”
(FYI, in August 2008, Citibank sold a similar portfolio for $0.22 per $1.00 face amount).

Liquidity Ratios measure an entity's sources of cash relative to its near-term cash obligations.
Operating sources of cash include, for example:
 Current Assets.
 Cash Flow from Operations.
 Revolving Lines of Credit.

Examples of near-term cash obligations are:

 Current Liabilities.
 Cash Flow into Operations (for operations that are losing money).
 Interest Expense.
(Note that depreciation is not a cash obligation).

Current Ratio (CR)

Current Ratio (CR) measures current assets relative to current liabilities. It is defined
mathematically as:
CR ≡ Current Assets / Current Liabilities

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 36

The ratio puts the assets an entity expects to turn into cash within a year in the numerator, and
the firm's cash obligations coming due within a year in the denominator. Typical usage is
something like “our Current Ratio is 1.7”. As with virtually all Liquidity Ratios, bigger is better,
within reason. The Current Ratio is applicable to all types of entities.

Looking at the components of the CR, you might think that a ratio of less than 1.0 would be a
bad sign. This is usually but not always true. As we saw with the Cash Level Ratio, a firm may
be able to raise cash quickly through a revolving loan, although this ability to borrow is not
recorded as a current asset. In this case the firm may carry a CR of less than zero, but have
plenty of liquidity.

Working Capital Ratio (WCR)

To discuss the Working Capital Ratio (WCR), we first need to define “Working Capital
Accounts” and Working Capital. A firm's Working Capital Accounts include all its asset and
liability accounts that are associated with its day-to-day business. This includes both current and
non-current accounts. Assets and liability accounts that are associated with financing or
investment are not Working Capital Accounts, whether they are current or non-current.

Working Capital accounts include, for example:

Accounts Receivable, Inventory, Accounts Payable, and Pre-Paid Expenses (even if non-current).
Examples of non-Working Capital accounts include: Short term Portion of Long Term Debt,
PPE, and all equity accounts.

Next up, we need to define Working Capital. This is simply the difference between a firm's
Working Capital assets and its Working Capital liabilities:
Working Capital ≡ Working Capital Assets – Working Capital Liabilities
Working Capital measures how much more cash and normal-business, transitory assets an entity
has than normal-business, transitory liabilities. I think of this as roughly as an entity’s excess
cash and normal-business transitory assets.

Good to Know:
A firm's Short Term Investments account may or may not be a Working Capital Account. If in
doubt, to be safe, this account should be excluded from Working Capital.
Why? Consider that a given company’s Short Term Investments may include, for example:
 CDs, short-term treasuries, and similar instruments, or
 Long-term bond investments that happen to be maturing soon, and long-term stock
investments that the entity has recently decided to sell.
The first set of items are properly part of working capital, but the second set are investment-
related items that should be excluded.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 37

Here is a real-world example:
For many years, Ford owned about 20% of Mazda's stock, which it reported as a Long-Term
Investment on its Balance Sheets. In 2010, Ford announced its intent to sell most of this stake.
On the company's next Balance Sheet, Ford properly reported the stock as Investment Held for
Sale. This was clearly not a Working Capital Account, even though it was a current asset.
However, many services that provide condensed financial statements to investors and analysts
threw the investment amount into Ford's Short Term Investments account. This erroneously
inflated the value of Ford's Working Capital assets.

The moral of this story is to be careful about what you include in Working Capital Accounts. If
in doubt make conservative assumptions or look up detailed financial reports at the SEC's
website.

Finally we are ready to look at the Working Capital Ratio (WCR). The WCR measures a firm's
Working Capital relative to its Working Capital assets. IE:
Working Capital Ratio ≡ Working Capital / Working Capital Assets
This ratio measures the excess of an entity's day-today, operating business assets, as a percentage
of its total day-today, operating business assets. It is a useful ratio for all types of entities, with
the caveat that it may be omitting liquidity in the form of an undrawn loan.

Fixed Cost Ratio (FCR)

The Fixed Cost Ratio (FCR) aims to measure earnings available to pay interest, relative to
interest obligations. It is defined mathematically as:
Fixed Cost Ratio ≡ EBIT / Interest
In general, the FCR should be greater than 1. Lower values indicate that a firm's operations are
not generating enough earnings to pay the interest owed on its debt.

EBITDA Sustainability Ratio (EBITDA-S)

To tackle this ratio, lets first define EBITDA and remind ourselves what CAPX is. EBITDA
stands for “Earnings Before Interest, Taxes, Depreciation and Amortization.” A firm's EBITDA
should always be positive. Negative EBITDA suggests that an entity may not be able to meet all
its financial obligations.

Recall that CAPX is short for Capital Expenditures, and represents net cash payments for PPE.
CAPX is reported on the “Cash Flows from Investing” portion of a firm's Cash Flow Statement.
For a large entity operating in a “steady state” capacity, CAPX over a quarter or year should be
similar to depreciation measured over the same time-frame.

With all this in mind, the EBITDA Sustainability Ratio (EBITDA-S) is defined as:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 38

 EBITDA Sustainability Ratio ≡ EBITDA / (Interest + CAPX)
The ratio aims to measure how much earnings a firm makes available to pay unavoidable costs
(costs that ensure the entity's medium-term sustainability). Expenditures other than interest and
CAPX are arguably not imperative for ensuring a firm's financial future. Depreciation, for
example, is never a cash expense. Similarly, a firm will incur no Tax Expense if it is just
scraping by. By contrast, interest is crucial because a missed payment (a “default”) may trigger
bankruptcy. CAPX is also essential in the medium term, because it is used to maintain a firm's
PPE.

The Sustainability Ratio is useful for all types of entities, even those with little or no PPE. For
firms with no PPE, the CAPX term will drop out and depreciation will be zero, reducing this
ratio to something like the Fixed Coverage Ratio: EBIT / Interest.

A weakness in the EBITDA-S Ratio is found in its CAPX term. In terms of sustainability, we are
only concerned with “maintenance CAPX.” This is the amount of CAPX an entity needs to
invest to keep its PPE operating properly. Reported CAPX may be significantly higher than
maintenance CAPX for healthy, growing companies, which are investing in new PPE. Similarly,
an unhealthy entity's CAPX may be distorted by sale of PPE while downsizing. An unhealthy
company may also postpone its PPE maintenance, and report a small level of CAPX that is not
sustainable. So, as with many ratios, we must be careful in our use of EBITDA-S, and perform
additional research to understand its constituent parts.

Our last two ratios, the Nominal Interest Rate and Depreciation Test, are not true Liquidity
Ratios. I include them with the Liquidity Ratio class because they both provide information
about the financial sustainability of an entity, which is what Liquidity Ratios are often used to
measure.

Nominal Interest Rate (NIR)

The Nominal Interest Rate (NIR) measures the average annual rate of interest that an entity pays
on all its debt. Mathematically:
Nominal Interest Rate ≡ Interest Expense(annualized) / Total Debt(BOP) (NIR, expressed as %)
Units are annual (% per year). This implies as usual that quarterly interest must be multiplied by
four to obtain annual units.

The NIR is an appropriate ratio for any type of entity (Industrial, Service, or Financial). In
general, the smaller the NIR the better, and an NIR that is decreasing over time is better than a
ratio that is increasing. However, these notions need to be tempered by general bond market
conditions. In 2013 for example, corporate bond interest rates rose across the board, making it
difficult for any single entity to reduce its NIR.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 39

Depreciation Test (DT)
The Depreciation Test Ratio (DT) measures an entity's depreciation in a period relative to its
CAPX:
Depreciation Test ≡ Depreciation / CAPX
The DT Ratio for rapidly growing companies will usually be less than one, as they add to their
PPE. Large, steady-state firms may ofter report a ratio of about one. A DT Ratio larger than one
may indicate that an entity is under-maintaining its CAPX and therefore impairing its medium-
term sustainability.

EXAMPLE:
LIQUIDITY RATIOS FOR UAL AND LUV
Consider these ratios for UAL and LUV, and answer the questions below.

1. Based on TTM results, which company best plans for its near-term obligations? Is the other
company unsafe?

Using the Current Ratio, we see that UAL appears to be better prepared (with a CR of 1.04
vs 0.93 for LUV). Even with a CR of less than 1.0, LUV is not unsafe. We should keep in
mind that the CR may not be telling the whole picture, as LUV may have (for example) an
undrawn credit facility that could use to meet some near-term obligations.

2. Is the trend in UAL’s EBITDA-S Ratio good or bad? Are recent levels of this ratio
sustainable?

The trend is clearly bad. UAL's Q6 vs Q2 EBITDA-S Ratios are 125% to 38%, and Q5 vs

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 40

 Q1 is equally as alarming. UAL's current EBITDA-S Ratio is clearly unsustainable. In Q1
(its most recently reported quarter), the company earned only 54% of its Interest Expense
and CAPX.

3. How would you rate UAL’s interest-rate management over the past seven quarters (good,
neutral, bad)? Why?

UAL's interest rate has been holding relatively steady, and has declined significantly in the
past quarter. This is a pretty good achievement for a company facing the headwinds we
have discussed throughout this chapter. For these reasons I'd give UAL a “good” grade.

4. What does LUV’s TTM DT Ratio say about its growth? Is this consistent with its revenue
and its overall financial state?

LUV's DT shows that the company is expanding its PPE base (IE: increasing its fleet of
planes). This makes sense, given the firm's healthy financial state and its annual revenue
growth of about 12%. LUV's strategy may be expand capacity while others in the industry
are weak.

5. Has UAL’s management of its Capital Expenditures improved over the past three quarters?
Why or why not?

Yes. A year ago, UAL was underfunding its CAPX, as measured by its DT Ratios of 131%
to 152%. By contrast, in two of the past three quarters its DT Ratio has been less than 57%,
indicating that it has tried to catch up on CAPX payments and PPE maintenance.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 41

 CHAPTER APPENDIX I
UAL’S FINANCIAL STATEMENTS USED FOR THE
ABOVE RATIO ANALYSES.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 42

 CHAPTER APPENDIX II
COMMON-SIZE FINANCIAL STATEMENTS
The basic idea behind Common-Size Financial Statements is to show Income Statements,
Balance Sheets, etc. with all quantities normalized to a key item. For example, a Common-Size
Income Statement shows each quantity as a percent of sales in the period. (So here, sales is the
key normalizing item). By comparing Common-Size Income Statements for several periods, we
can quickly determine if costs are rising relative to sales, or if profit (Net Income) is increasing
in proportion to sales.

Similarly, Common-Size Balance Sheets show all items on a company's Balance Sheet as a
percent of its total assets. Again looking at statements from several adjacent periods, we can
quickly determine, for example, if a company's debt is increasing relative to its assets (increasing
the entity's financial risk), or whether its equity base is shrinking.

COMMON-SIZE STATEMENTS EXAMPLE:

UNITED AIRLINES (UAL) DURING THE GREAT RECESSION
Lets create and scrutinize United's (UAL's) Common-Size Income Statements for part of the
Great Recession.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 43

Here are UAL's Income Statements for the six quarters ending 6/30/2008:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 44

To make these Common-Size Statements, we divide each entry of each quarter's Income
Statement by the sales (Revenue) of the quarter. For example, SGA for the quarter ending
12/31/2007 will be:
Cost of Goods Sold (COGS) / Revenue = 3102 /3523.0 = 88.0%
Performing this division for each item in each quarter yields six Common-Size Statements for
UAL:

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 45

The best place to start reviewing Income Statements is usually with Revenue and Revenue
growth. This is because Revenue is the cardinal measure of the scale of a firm, and because
many changes in companies' performance are down to changes in sales.

For studying Revenue and Revenue growth, UAL's raw Income Statements are actually more
helpful than its Common-Size equivalents, because all the Common-Size sales numbers read
100%. So lets put this research aside for now, and look at the second best place to start
reviewing an Income Statement: Net Income. Net Income is good to look at because, as we
know, it shows what a company earns from day-to-day operations, after also making required
payments like interest, taxes, etc.

A quick glance shows us that UAL's Net Income is collapsing. It declined from 0.7% of sales in
the quarter ending 3/31/2007 to -3.5% in the quarter ending 3/31/2008. Worse, UAL's Net
Income swung from 6.3% of sales in the 6/30/2007 period to -1.1% in the period ending 6/30
2008.

Our next step is to suss-out why UAL's Net Income is dropping. For this we scan other Income
Statement items for big changes. We see that UAL's Cost of Goods Sold (COGS) has increased
over the same periods that its Net Income has declined from 81.6% to 85.5% and 75.8% to
84.1% respectively. A careful review of all the Income Statement items confirms that these are
the biggest increases in UAL's expenses by far.

UAL's COGS-to-sales increases resulted from either its revenues decreasing relative to COGS, or
its COGS increasing relative to sales. By looking at UAL's raw Income Statements, we see that
sales have been growing (year over year) by about 9% to12%. From this we infer that the
problem is not caused by a sales decline. Instead UAL's COGS Expense has been increasing
faster than its revenues.

The reason for UAL's COGS increase in this period is the skyrocketing price of jet fuel. For
airlines, fuel is part of COGs Expense. In the period we are reviewing, the jump in jet fuel
prices has driven up UAL's COGS expense so much that it caused the firm's Net Income to swing
from positive to negative.

We could perform a similar analysis of UAL's Balance Sheets by preparing Common-Size

Balance Sheets. This would yield several decent insights, but I think our time will be better
spent by moving on to a more useful technique.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 46

LIMITS OF THE COMMON-SIZE STATEMENT
METHOD
One problem with the Common-Size Statement method is that it includes a lot of unhelpful
information. UAL's Common-Size Income Statements, for example, show both COGS and
Gross Profit ( = Revenue - COGS). Both of these items give us the same insights, packaged in
slightly different ways. Ideally, we'd like to work with a method that provides just the numbers
we need, instead of the shotgun approach provided by the Common-Size method.

Another problem with the Common-Size method is that it restricts us to considering only ratios
from one type of financial statement at a time, with only one constant value (Revenue or total
Assets) in the denominator of each ratio. It would be more helpful to use any appropriate
number in the denominator of our ratios, and to compare numbers from more than one financial
statement at a time.

FINANCIAL STATEMENT ANALYSIS: PART I PAGE 47

 FINANCIAL STATEMENT ANALYSIS
PART II:
RATIOS DERIVED FROM MARKET DATA
AND FINANCIAL STATEMENTS

CHAPTER 13
 EQUITY (STOCK) INVESTING BASICS
Before we start studying ratios that include data from stock markets, lets consider the basics of
equity investing, and compare some key stock market quantities to their GAAP accounting
analogs.

Firstly, the stock marketplace’s meaning of “equity” is not the same as the meaning in GAAP
accounting. Recall that in GAAP accounting,
Equity ≡ Assets – Liabilities
In the stock market, equity refers to ownership of a company. Shares of stock represent slices of
ownership. If someone purchases all the shares of an entity's stock, they become the sole owner
of the firm. In stock markets, shares are freely traded, implying that the ownership of companies
who's shares trade in these markets have constantly changing ownership profiles.

Equally important, the marketplace constantly revalues through changes in their share prices. At
all times, the market's estimate of a company's worth is:
Value of Company ≡ EquityMV = Share Price * Number of Shares Outstanding
As we see, EquityMV is not necessarily related to EquityGAAP.

EQUITY INVESTING EXAMPLE, SMALLCO

Lets consider a year in the life of SmallCo Inc. At BOY 1, SmallCo:
 Raises $100MM cash for 100% ownership of the company, by issuing 100MM shares of
stock at $1/share.
 Has this GAAP Balance Sheet ($MM UON):
Cash $100 Equity (PIC) $100
 Lists its shares of stock (pieces of its ownership) for trading on OTC-Link, an SEC-
sanctioned over-the-counter market.1

As SmallCo operates through year one, some of its stock is bought and sold on OTC-Link. At
the end of the year (EOY 1), OTC-Link lists SmallCo's closing stock price at $2/share. As noted
above, the market value of SmallCo’s Equity is equal to the product of its outstanding shares of
stock and the price that the shares trade at. This puts the market value of SmallCo’s Equity at
$2/share * 100MM shares = $200MM. So it would nominally2 cost $200MM at EOY 1 to
obtain 100% ownership of SmallCo buy purchasing all of its shares.

1 Unlike the NASDAQ and NYSE marketplaces, OTC-Link has no listing requirements. IE: virtually any
American company's stock can be traded on the OTC-Link platform. http://www.sec.gov/answers/pink.htm
2 “Nominally” because initiating the process of buying all of SmallCo’s shares would almost certainly drive up
the price per share. So the average price per share when buying all available shares would likely be more than
$2.

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 2

Soon after EOY 1, SmallCo reports:
 Net Income for Y1 of $10MM.
 This GAAP Balance Sheet, as of EOY 1:
Assets $110MM
Liabilities $0MM
Paid in Capital $100MM
Retained Earnings $10MM
Total Equity $110MM

At EOY 1, SmallCo's EquityMV of $200MM is uncoupled from its EquityGAAP of $110MM.

$200MM is the marketplace’s estimate of SmallCo’s worth, while $110MM is equal to
SmallCo’s GAAP-valued Assets minus its Liabilities.

THE IMPORTANCE OF EQUITY MARKET DATA TO STOCK INVESTORS

Ratios derived from market data combine some market quantities (such as EquityMV and price per
share) with data from GAAP financial reports. These ratios are particularly helpful to equity
investors, who are deciding whether to buy, hold, or sell an entity's stock (IE: whether to buy,
hold, or sell an ownership stake in the entity). Specifically, stock investors use market-data
ratios to help answer questions like:
 Is the marketplace’s valuation of a company's worth correct?
 If not, will the marketplace’s value converge to my view of the correct value?

Answers to these and similar questions are crucial for stock investors. Its worth noting that these
questions are generally more difficult to answer than the questions we've addressed using
financial-statement-based ratios. Financial-statement-ratios are good for the needs of most debt
investors, who want to answer these kinds of questions:
 Will the company do well enough to pay me back?
 How risky is this company compared to its comps?
 Which companies’ bonds should we buy?
 Which is the best company to make a loan to?

COMMON TYPES OF EQUITY INVESTORS

Most Equity investors (stock investors) can be broadly grouped into three categories:
1. Value Investors
Value Investors aim to determine the worth of a given entity, and may choose to purchase
shares of its stock if they believe the company's market valuation (EquityMV) is less than the

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 3

 firm's true value. Value investors use tools like the Balance Sheet Valuation method.
Practitioners include Warren Buffet, Mario Gabelli, and Meryl Witmer.
2. Relative Value Investors
These equity investors analyze most companies in an industry or economic sector, and
purchase shares of entities' that they think will outperform their peers. They may also bet
against the companies that they believe are the worst in the sector.
3. Growth Investors
Growth investors search for companies with fast growing Revenue, and ideally with Net
Income growing faster than Revenue. These investors are betting that the equity value of the
firms will appreciate as their Sales, Net Income and market shares increase.

REWARD AND RISK CONSIDERATIONS

Giving short shrift to the consideration of financial reward and (especially) risk has calamitized
many investors. Unfortunately, the robust consideration of reward and risk is tricky, and
complicated enough to be the subject of entire textbooks. However, the general concepts of risk
and reward are straightforward and deserving of mention alongside our discussion of investor-
types.

Reward and Risk Considerations for Debt Investors:

In terms of financial reward, debt investors are typically concerned with questions like “What
will our return or yield be on this investment (bond or loan), assuming the company meets the
terms of the bond or loan contract?” Here return means simply:
(what we get out minus what we put in) / (what we put in).
Yield is a similar but more sophisticated measure that takes into account the time value of
money.

In terms of financial risk, debt investors should carefully consider questions like this:
 What could go wrong with our reward estimate?
IE: Will the company default on its bond or loan contract?
 What is the probability that our reward estimate is incorrect?
 How big a loss could we incur if our reward analysis is wrong?

Reward and Risk Considerations for Stock (Equity) Investors:

Financial rewards for equity investors are centered around questions like “How much more can
we sell this stock for in future, compared to current purchase price?” and “What will our return
be if we can sell for this estimated future price?”

Risk considerations for equity investors are very similar to considerations addressed by their
debt-investing counterparts. Central risk questions for equity investors include:
 What could go wrong with our reward estimate?
IE: Will the stock fail to appreciate?
 What is the probability that our reward estimate is incorrect?
 How big a loss could we incur if our reward analysis is wrong?

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 4

RATIOS DERIVED FROM MARKET DATA
AND FINANCIAL STATEMENTS
Now lets look at some ratios that incorporate stock market data as well as financial statement
information. First up is a new take on ROE:

Return on Equity(Market Value) Ratio (ROE(MV))

ROE(MV) measures how much Net Income an entity generates relative to its BOP stock market
value. Mathematically, its defined as:
ROE(MV) ≡ NI(annualized) / Equity(MV, BOP) (ROE(MV), expressed as %)
Note that this ratio is the same as our previous incarnation of ROE, except that Equity(MV, BOP) has
replaced Equity(GAAP, BOP) in the denominator. ROE(MV) is a useful ratio for all types of entities. As
with traditional ROE, most investors would ideally like to see ROE(MV) positive, large and
growing.

Price to Earnings Ratio (PE)

The Price to Earnings (PE) Ratio is probably the most commonly used ratio in equity analysis. It
measures the amount shareholders pay for each dollar of a company's Net Income.
Mathematically, the PE Ratio is defined as:
Price to Earnings ≡ Equity(MV, Today) / NI(annualized) 1a)
The PE Ratio is almost the same as 1/ ROE(MV). The difference is that, Equity(MV) is measured as
of today for the PE, but is measured at BOP for ROE(MV).

On a per-share basis, the PE ratio is written as:

PE = Price-per-Share(Today) / Earnings-per-Share(annualized)
where Earnings-per-share is approximately NI / (Number of Shares Outstanding).3 By
multiplying the numerator and denominator by Number of Shares Outstanding, this version of
the PE becomes the same as 1a) above.

There are several common methods of computing PE ratios. Here are two common ones:
1. PE(Historical) ≡ Equity(MV, Today) / NI(TTM)
Where “TTM” stands for “Twelve Trialing Months.” This version uses the most recently
reported twelve months worth on Net Income (or the past four quarters NI if measuring
quarterly).

3 I say “approximately” because there are several commonly-used measures of “shares outstanding.” One
measure includes, for example, shares that would be outstanding if all options owned by an entity's employees
were exercised. The detailed discussion of this topic is beyond the scope of this introductory text.

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 5

2. PE(Forward) ≡ Equity(MV, Today) / NI(TFM)
Where “TFM” stands for “Twelve Forward Months.” This version uses the Net Income that
a company is estimated to deliver in the next twelve months (or the next four quarters if
measuring quarterly).

Neither of these versions is ideal. Note that the second variant of the PE requires an estimate of
the entity's future Net Income. As a large cadre of equity analysts can confirm, this is usually
very difficult to predict. On the other hand, while the entity's NI(TTM) is reported on its Income
Statements, its not clear that the future will look like the past and that this historical number says
much about the entity's future performance.

Interpretations of PE ratios can vary widely among analysts and investors. A company with a
low PE, for example, will inevitably be interpreted by some as an entity whose stock is selling at
bargain prices. To others, it will mean that the company is troubled and should be avoided.

A good example of how disparate equity investors' views can get was seen in a Columbia
University Business School symposium held around 2006. Bill Miller, an invited speaker
celebrated as one of the best value investors of his generation, mentioned that Kodak was one of
this best stock picks. Jim Chanos, the next speaker and arguably the best “short selling” hedge
fund manager of his time, quickly countered that Kodak was among his most important short-
sale trades. (A “short seller” sells shares of a company's stock that he does not own, in the hope
that he can buy them back later at a lower price). Chanos turned out to be right – Kodak's stock
dropped from 35 to about 5 during the next year, but at the time it was unclear to this audience
member who was right.

PE to Growth Ratio (PEG)

The PEG ratio measures how well Sales Growth balances a high PE ratio. It is formulated as:
PEG == PE / Annualized Growth in Sales
It is primarily used by growth investors. Smaller is considered better by many analysts.

Like the PE ratio, the PEG ratio may be computed on TTM or Forward (TFM) basis:
PEG(TTM) = PE(TTM) / TTM Sales Growth.
PEG(TFM) = PE(Estimated TFM) / Estimated TFM Sales Growth

Dividend Yield (DY)

Dividend Yield (DY) measures what percentage of an entity's market value has recently been
distributed to owners as dividends. IE:
Dividend Yield ≡ Dividend(annualized) / Equity(MV, BOP) (DY, expressed as %)
= Dividend per Share(annualized) / Price per ShareBOP

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 6

DY is a ratio that is applicable for all entity types. It is most important for large, slow-or-
medium growth companies, because, smaller faster growing entities tend not to pay dividends.
(These entities usually plow any excess cash into growing their business). For applicable
companies, bigger is better for this ratio. All else being equal, stock investors prefer companies
with higher dividend yields.

Payout Ratio (PR)

The Payout Ratio (PR) measures how much of an entity's Net Income it distributes to its
shareholders as dividends. Although the Payout Ratio does not rely on market data, I present it
here because it is often used with the Dividend Yield ratio. Mathematically, the Payout Ratio is
expressed as:
Payout Ratio ≡ Dividend / NI (Expressed as %)
= Dividend per Share / EPS
The PR has the same applicability as the Dividend Yield ratio.

FYI, REITs maintain their no-income-tax status by monitoring a very similar ratio. REITs
measure Dividends divided by Taxable Income (instead of Net Income), and they qualify to
avoid income tax by keeping this ratio at 90% or more, on an annual basis.

Debt to Enterprise Value Ratio (DtEV)

Before jumping into this ratio, lets define Enterprise Value (EV) as the sum of an entity's total
debt and the market value of its equity. IE:
Enterprise Value ≡ Total Debt + Equity(MV)
Note that EV is similar to Capitalization. The only difference is that EV measures equity on a
market-value basis, instead of on a GAAP basis.

EV represents what you may pay to purchase 100% of a firm, assuming the entity's lenders have
a “change of control put.” A change of control put gives lenders the right to make
loans/bonds/etc fully due if the controlling ownership of a firm changes. This protects lenders
from new owners that may be disinclined to make debt payments a top priority.

For example, lets say you are the 100% owner of WEA, and the firm has an outstanding loan
from J.P. Morgan for $6,000. Now you agree to sell me the firm for $12,000. J.P. Morgan,
thinking me unsavory,4 exercises its right to demand repayment of the loan ($6,000) at the time
of sale. In this case, I would have to either pay $18,000 for the firm ($12,000 to you and $6,000
to J.P. Morgan) or find another lender to loan WEA $6,000. The proceeds of the new loan would
be used to pay off J. P. Morgan.5

4 Arguably with good reason.

5 There are actually many other possibilities. For example, I may find a bank to loan WEA $15,000. In this case,
I would invest just $3,000 of my own capital to purchase the firm. The loan proceeds would be used to pay the

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 7

Now lets get back to the Debt to Enterprise Value Ratio (DtEV). This ratio measures debt as a
percentage of enterprise value. Mathematically:
Debt to Enterprise Value Ratio ≡ Debt (long and short term) / (Debt + EquityMV)
= Debt / Enterprise Value ( DtEV, expressed as %)
DtEV is a leverage ratio, which is similar to the Debt to Capitalization ratio. The only difference
is that DtEV replaces GAAP equity with EquityMV. As with virtually all leverage ratios, bigger
values indicate greater financial rewards for owners in good times, but more downside risk in
bad times. DtEV is applicable to all entity types.

MARKET DATA RATIOS EXAMPLE

Consider the below financial statements, sales analysis and market data for CAL:

you (the existing owner) and J.P. Morgan (the lender).

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 8

Here are the market-data-based ratios we have covered in this chapter, as computed with this
data:

You should be sure that you can compute all these ratios, using the definitions provided above.

Notice that I have sneakily included LUV’s sales growth, as well as its TTM ROE and TTM PE
ratios. This allows me to ask: Which company’s stock would you prefer to purchase, based on
your consideration of sales growth, ROE ratios and PE ratios?
Solution:
The answer depends on your investment methodology. For example, value investors may make
different choices than growth investors.
Note that, during the past year LUV produced higher earnings per dollar of BOP market value
than CAL (as measured by ROEMV). However, based on today's prices per share (or Equity(MV,
EOP)), each dollar of LUV's TTM earnings costs almost 1.4 times as much as CAL's (as measured

by PETTM). Given these data, potential investors may ask, for example, “should we pay up for
LUV, assuming that it will continue to outperform CAL on an ROE basis, despite its relatively

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 9

high PE ratio?” Wading through data like these and questions like this are everyday challenges
for equity investors.

Enterprise Value to EBITDA Ratio (EvtEBITDA)

Enterprise Value to EBITDA Ratio (EvtEBITDA) measures how many years it would take to
generate a firm’s EV, if 100% of its EBITDA could be devoted to this effort. It is computed as:
EvtEBITDA ≡ EVEOP / EBITDA(annualized) (Expressed in years)
This ratio is a distant cousin of the Debt to EBIT leverage ratio covered in the last chapter.
Higher values of EvtEBITDA generally indicate higher financial risk.

EXAMPLE:
USE OF EVTEBITDA IN RESOLVING CHAPTER 11 BANKRUPTCIES
Here is a simplified explanation of how an entity falls into bankruptcy:
 It takes out loans and/or issues bonds. These contracts typically give lenders (creditors) the
right to demand immediate, full reimbursement if the entity misses an interest or principal
payment. The contracts further give lenders the right to take ownership of the company if
the borrower cannot fully reimburse them. (Think of the bank foreclosures in The Grapes of
Wrath).
 The borrowing entity performs poorly, and “defaults” on one or more debt payments.
(“Default” means “miss a payment”).
 To avoid immediately losing ownership of the entity, its owners file for Chapter 11
bankruptcy protection6 in a Bankruptcy Court. If accepted, this filing prevents takeover by
the entity's lenders for a period of nine months or more. During this time, the entity is
allowed to continue operating.
 In return for receiving Chapter 11 protection, the entity agrees that a bankruptcy judge will:
 Control its operations.
 Determine which creditors will be paid when.
 Decide how to change the entity's financial structure to avoid another bankruptcy filing
in the future.

Bankruptcy judges and their advisors use EBITDA and EvtEBITDA to help establish a proper
financial structure for firm's in Chapter 11 protection. Here is how it works:
 Say HCP misses a bond payment and files for Chapter 11 bankruptcy protection.
 At the time of filing, the firm’s bondholders are owed $800MM, and the company's TTM
EBITDA is $100MM.

6 Another type of filing, Chapter 7, protects firms with no hope of future viability to wind down their operations
and liquidate in an orderly way.

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 10

 Irrespective of what the bondholders are owed, the bankruptcy judge will establish a new
financial structure for HCP (IE: a new mix of debt and equity), which will keep the firm
from falling into bankruptcy again. The judge will reduce the amount of HCP's debt and
interest payments to make this work.
 The judge computes the average EVtEBITDA of HCP's financially-healthy competitors as 6.
She concludes that HCP should be able to operate sustainably with the same EVtEBITDA
ratio, assuming its EV is not to heavily weighted toward debt.
 The judge now estimates HCP's Enterprise Value as follows:
EV = EVtEBITDA * EBITDA = 6 * $100MM = $600MM
 Given that HCP's creditors are owed $800MM, she rules as follows:
 HCP's current shareholders will be wiped out, and have no ownership of the restructured
company.
 HCP's creditors will take a $200MM “haircut” and receive $600MM of new debt and equity
(stock) in the new company.
 To ensure that HCP does not have too high a debt and interest payment burden going
forward, the judge declares that creditors will get (say) $300MM in new debt and 100% of
the company's stock, which she values at $300MM. (Of course the stock marketplace will
set its own value on the first day that the company's new stock trades on an exchange). Now
the firm's total debt and equity add to $600MM, equal to the judge's estimated Enterprise
Value.

In summary, the judge estimates HCP's Enterprise Value at $600MM, all of which is legitimately
claimed by the firm's lenders. In order to keep HCP's future interest payments manageable, she
cuts its debt burden from $800MM to $300MM, and she transfers 100% of the HCP's ownership
to its lenders. She values the 100% ownership stake at $300MM (which will be supersceded by
a marketplace valuation when the stock begins to trade), bringing HCP's total EV to $600MM.

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 11

RATIOS DERIVED FROM MARKET DATA AND FINANCIAL STATEMENTS PAGE 12
 SOURCES AND USES
AND
THE INDIRECT CASH FLOW STATEMENT
CHAPTER 14

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 1
 CASH ANALYSIS
In the world of accounting and finance, cash is truly king. Cash matters because we use it to
measure value, to predict whether a company will declare bankruptcy, to gauge the safety of a
company and to determine countless other financial metrics.

Cash analysis often begins with several straightforward questions, such as:
 How much cash does a company have relative to its needs?
 What are the entity's sources of cash?
Its operations? Equity and/or debt financing?
 What is the company using cash for?
Supporting unprofitable operations? Purchasing PPE or other entities? Repaying loans?
Paying dividends? Buying back its stock?
 How does the company's current cash management compare to its history or to comparable
companies (“comps”)?

CASH ANALYSIS TOOLS

The primary tools for cash analysis include the following:
1. Cash Ratio Analysis
As we learned in the ratio analysis chapters of this text, cash ratios compare a company's
cash levels or flows to items drawn from its financial statements. For example, the Cash-
Level Ratio is defined as:
(Cash and Equivalents)EOP / Sales.
It measures how much cash a company is keeping on hand relative to its sales.
2. Sources and Uses Statements
These useful reports categorize changes to an entity's accounts in a period as “Sources” or
“Uses” of cash.
3. Cash Flow Statements
As we have seen, there are two main types of cash flow statements – the Direct Method
Statement, which we have learned to create, and the Indirect Method Statement, which we
will cover in this chapter.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 2
 SOURCES AND USES STATEMENTS

INTRODUCTION TO SOURCES AND USES

Sources and Uses statements (SU statements) identify “Sources” and “Uses” of cash through
changes in accounts during a given period. “Sources” and “Uses” are in quotes because they
have more general definitions than simply cash inflows and outflows. Before we get to careful
descriptions of these terms, lets see how SU statements are created:

As with all financial statements, the individual terms of an SU statement will come from a
Transaction Table or set of journal entries. Building an SU statement begins with with the Δ
form of the Fundamental Accounting Equation for a given period:
Δ Assets = ΔLiabilities + ΔEquity

Next we expand terms and use the magic of algebra to solve the above equation for total change
in cash:
Δ Cash = ΔLiabilities + ΔEquity – (Δ All Other Assets) 27d)

Lastly, we organize the right hand side of 27d) into “Sources” and “Uses” of cash. IE:
Δ Cash = Sources – Uses 27e)

Now note that, for example, increases in liabilities (like Notes) or equity (like PIC) could be
sources of cash, and increases in assets (like Inventory or PPE) could be uses of cash. This
suggests relating 27d) and 27e) as follows:

Δ Cash = Sources – Uses . 27e)

Δ Cash = Increases in L and E – Decreases in L and E 27f)
+ Decreases in Assets – Increases in Assets

27e) is called the Sources and Uses Equation, and it is the form of the Fundamental Accounting
Equation we use to officially define “Sources” and “Uses” of cash:
A “Source” of cash == an increase in a Liability or Equity account, or
a decrease in an Asset account.
A “Use” of cash == an increase in an Asset account, or
a decrease in a Liability or Equity account.
With these definitions, Sources and Uses are either account-changes that result in cash flows or
changes that could result in cash flows. So, Sources and Uses can be thought of as ‘generalized,’
actual sources and uses of cash.

Here are some illustrative examples:

1. Buy Inventory, paying cash:
This transaction causes a cash outflow, used to increase Inventory.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 3
 So the increase in the Inventory account is a Use.

2. Take out an informal loan with a Note:

This transaction increases an entity’s cash and its Note Payable Liability. Here we say that
the entity Sourced cash by increasing its Note Liability, and that the increase in the Note
Liability is therefore a Source.

3. Buy Inventory with a Note:

Here an entity gets Inventory in return for promising to a pay vendor cash in the future. For
this transaction we record Inventory ↑ and Note Payable ↑. Following our definitions of
Sources and Uses, the increase in Inventory is a Use of cash, as it was in Example 1.
Similarly, the Note Payable increase is a Source of cash (as an increase in a liability
account). The Note Payable increase can also be recognized as a Source by noting that it
could have been associated with a direct cash inflow, as we saw in Example 2.

4. Perform a Leveraged Debt for Equity Swap:

Consider an entity making this contract with a bank:
§ The bank agrees to immediately buy some of the entity’s shares in the stock marketplace,
and deliver them to entity for retirement.
§ The entity agrees to pay bank back the amount spent by the bank, over time with interest.
This arrangement is like a normal loan contract, except that its a bit more complicated than
usual.
For this contract, the entity records PIC ↓ and Loan ↑.
In this case, Loan ↑ is still a Source (as an increase in a liability account), and PIC ↓ is a Use
(as a decrease in an equity account). The decrease in PIC can also be recognized as a Use by
noting that it could have been associated with a direct cash outflow, as it was in WEA’s
buyout of Partner 2 in an earlier chapter.

As these examples show (and as noted above), we can always think of “Sources” as events that
generate cash inflows or could have generated cash inflows. Similarly, we can think of “Uses”
as events that generate cash outflows or could have generated outflows.

Properties of Sources and Uses:

1. Algebraic sign conventions:
Recall that we derived the Sources and Uses Equation from the Fundamental Accounting
Equation:
Δ Assets = ΔLiabilities + ΔEquity,
which we re-wrote as:
Δ Cash = ΔLiabilities + ΔEquity – (Δ All Other Assets) 27d)

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 4
 By inspection, anything in 27d) with a positive sign is a Source, and anything with a
negative sign is a Use. This knowledge will simplify our construction of SU Statements,
and ease the process of creating Indirect Cash Flow Statements.

2. PPE, Accumulated Depreciation and Net PPE:

In SU Statements (and Indirect CF Statements), its important to use either a Net PPE
account or PPE and Accumulated Depreciation accounts, but not both. This precludes
double-counting of PPE and Accumulated Depreciation, which makes it impossible to
generate correct statements. In this text, we will often use Net PPE for simplicity’s sake.

3. Relationship of debits and credits (drs and crs) to Sources and Uses:
Note that our formal definition of Uses is identical to our definition of account changes that
carry a “dr” in journal entries, and that our definition of Sources is the same as that for
account changes that carry a “cr” in journal entries. This knowledge makes it easy for us to
generate SU Statements directly from journals, as well as from algebraically-organized
Transaction Tables.

AN SU STATEMENT EXAMPLE
Consider GCC soon after startup. During a brief accounting period the company:
1. Gets $50K loan. 3. Buys $150K Mill, paying cash.
2. Raises $50K equity capital. 4. Nothing Else.

Find:
An SU Statement for the period.

Solution:
A. Create a Transaction Table for the period:
Event Δ Assets = ΔLiabilities + ΔEquity
1. 50 Cash 50 Loan
2. 50 Cash 50 PIC
3. 150 PPE(Mill)
-150 Cash
Totals 100 = 50 + 50

B. Re-arrange the Table to isolate ΔCash:

ΔCash = – (Δ Other Assets) + ΔLiabilities + ΔEquity
50 50 Loan
50 50 PIC
-150 – 150 PPE(Mill)
Totals
-50 = -150 + 50 + 50

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 5
C. Re-arrange the modified Table into SU Statement Form:
ΔCash = Sources – Uses

Sources and Uses Statement: GCC, for the period

ΔCash = Sources – Uses
-50 = 50 Loan – 150 PPE(Mill)
50 PIC
Totals
-50 = 100 – 150

Interpretation of the SU Statement

Referring to the above US Statement, we say GCC Sourced (obtained) cash by taking out a loan
and raising funds from equity investors. The firm Used this cash (and more) to buy a mill (PPE).

ANOTHER SU STATEMENT EXAMPLE

During another brief accounting period, GCC:
§ Buys $5K Inventory, gets invoiced.
§ Nothing else.

Find:
An SU Statement for the period.

Solution:
A. Create a Transaction Table for the period’s events ($K UON):

Event Δ Assets = ΔLiabilities + ΔEquity

1. 5 Inventory 5 AP
Totals 5 = 5 + 0

B. Re-arrange the Table to isolate ΔCash:

ΔCash = – (Δ Other Assets) + ΔLiabilities + ΔEquity

0 = – 5 Inventory + 5 AP + 0
Totals
0 = -5 + 5 + 0

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 6
C. Re-arrange the modified Table into SU Statement form:
ΔCash = Sources – Uses

Sources and Uses Statement: GCC, for the period ($K)

ΔCash = Sources – Uses
0 = 5 AP – 5 Inventory
Totals
0 = 5 – 5

Interpretation of This SU Statement

Even though no cash flowed during the period, GCC nonetheless generated Sources and Uses.
For this Statement we say that accepting the invoice was a Source of cash. (The invoice actually
could have generated cash. This would be weird but is possible). We similarly say that GCC’s
obtaining of Inventory was a Use of cash. (The Inventory could have been obtained by a cash
payment).

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 7
 THE INDIRECT METHOD
CASH FLOW STATEMENT
The Indirect Cash Flow Statement is arguably the most common method used to understand
entities' cash management practices and cash positions. Its mission in life and its key attributes
are identical to those of the Direct Method Cash Flow Statement.

As a reminder, the mission of a Cash Flow Statement is to report the movement of cash to and
from a firm over an accounting period. The Statement's key attributes are:
 Satisfying:
Cash(BOP) + ΔCash = Cash(EOP)
 Sorting cash flows into these three groups:
1. Cash flows from Operations (Operating-Cash-Flows)
2. Cash flows from Investing
3. Cash flows from Financing

The three cash flow groups are defined as follows:

1. Cash flows from Operations are Income Statement related flows. These include any cash
inflow or outflow from:
 A firm's day-to-day production and sale of products or services. Examples include:
 Paying for inventory.
 Receiving cash from product or service sales.
 Paying suppliers and employee salaries.
 Paying loan interest and taxes.

2. Cash flows from Investing are any non-Operating cash flows involving the investment of a
firm’s resources with 3rd parties. These include for example:

§ The purchase or sale of PPE.

§ The purchase or sale of another firm’s stock or bonds.
(Unless the Cash Flow Statement is being prepared for an entity in the business of trading
stocks and bonds).
§ Making loans, or receiving repayment of loan principal.

3. Cash flows from Financing are non-Operating cash flows to or from a firm’s stakeholders.
(IE: cash flows to or from the entity's owners {shareholders} and lenders).
Examples include:

§ Taking out a loan or repaying its principal.

§ Issuing a bond, or repaying a bond's principal.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 8
 § Issuing stock (+PIC) or repurchasing stock (-PIC).
§ Distributing dividends.

REVIEW: THE DIRECT METHOD OF CREATING

CASH FLOW STATEMENTS
Recall Cash Flow Statements are created with the Direct Method as follows for a given
accounting period:
 Locate all the changes to cash in the period's journals or Transaction Table entries.
 Note the reason for each cash flow, and categorize it as Operating, Investing or Financing.
 Format the categorized entries into Direct Method Cash Flow Statement format. Include
BOP and EOP cash balances from the appropriate Balance Sheets. Check that:
Cash(BOP) +Δ Cash(Cash Flow Statement) = Cash(EOP, as reported on BS)

INDIRECT CASH FLOW STATEMENT OVERVIEW

The Indirect CFS takes a different approach. Instead of starting with cash journal or Transaction
Table entries, it begins with the record of all account changes in a period. Also, in its Operating
section, the Indirect Statement highlights Net Income (NI) as computed on the period's Income
Statement. The resulting Cash Flow Statement includes Sources and Uses of cash, as defined
earlier in this chapter.

We will consider two variants of Indirect Cash Flow Statements – “Pure” and GAAP. First we
will develop what I call “Pure” Statements, then use these to create GAAP Statements.

Indirect Cash Flow Statements are derived by first rearranging and expanding the Fundamental
Accounting Equation, to isolate ΔCash and highlight Net Income in the period (ΔNI).
Start with:
Δ Assets = ΔLiabilities +ΔEquity
Rearrange and expand to identify Δ Cash and ΔNI:
Δ Cash + Δ All Other Assets = ΔLiabilities + Δ PIC + Δ Div1 + ΔNI
Isolate Δ Cash and highlight ΔNI:
Δ Cash = ΔNI - Δ All Other Assets + ΔLiabilities + Δ PIC + Δ Dividends1 a)

Next, the right-hand side of equation a) is expanded and rearranged into Operating, Investing,
Financing sections, with ΔNI becoming the first term in the Operation section.
1 Note the algebraically correct sign for Dividends.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 9
Note that, in equation form, a Direct Method Cash Flow Statement can be expressed as:
Δ Cash = Σ (Cash Account journal entries in period) b)

By comparing and contrasting a) and b) we see:

§ ΔCash a) = ΔCash b) = total cash flow in period.
(A true cash flow).
§ Each right-hand side entry of b) is a cash flow.
§ Each right-hand side entry of a) is not necessarily a cash flow.
However, each RHS entry of a) is always a generalized Source or a Use of cash, as
defined above.

HOW TO CREATE A PURE, INDIRECT METHOD

CASH FLOW STATEMENT

I. Operating Cash Flow Section

To build the Operating portion of the Indirect Cash Flow Statement, we expand, isolate and
rearrange some terms of equation a):
ΔCash = ΔNI - Δ All Other Assets + ΔLiabilities + Δ PIC + Δ Dividends aexpanded)

After making these algebraic changes, we have

Operating Cash Flow ≡
NI for period (Δ NI)
+/- portions of ΔAll Other Assets and ΔLiabilities from a), needed to convert from ΔNI to
“Cash-Associated Income” 22j)
+ Sources, – Uses from the Working Capital accounts in a). 31q)

So far so bad. Now we have a crazy, complicated definition of Operating Cash Flow that
includes two new, as-yet-undefined terms: “Cash-Associated Income” and “working capital
accounts.” At this point, you may be asking how we could possibly need such a convoluted
definition. There are actually three reasons for defining Operating Cash Flow like this. Two of
them are pretty good:
Reason 1:
"Accountants like confusion because it keeps us in business."

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 10
As stated by Kenneth E. Baggett, Co-CEO CohnReznick Accountants, during an interview on
Bloomberg radio.
Reason 2:
If we define the Indirect Method Operating Cash Flow (OCF) in this way, then
Indirect Method OCF = Direct Method OCF
This is exactly what we want. Any method we use should provide the same total Operating Cash
Flow as the Direct Method.
Reason 3:
By defining Indirect Method Operating Cash Flow in this way, we highlight the differences
between Operating Cash Flow and Net Income. This is very helpful because it shows how off a
firm's Net Income is from its Operating Cash Flow, and why the two numbers are different. All
things being equal, we'd like to see Net Income be as close to Cash From Operations as possible.

Lets define “Cash-Associated Income” (or simply “Cash Income”) and “Sources/Uses from
Working Capital Accounts,” and then compute Indirect Method Operating Cash Flow for an
example company.

Cash Associated Income (Cash Income)

≡ ΔNI minus the effect of components unassociated with ΔCash, except for inventory-related
expenses.
Inventory-related expenses include COGS and Inventory Write-Downs. We will account for
inventory-related items later, when addressing “Sources/Uses from Working Capital Accounts.”
(See line 31q in the definition of Operating Cash Flow).

Components of ΔNI that are not associated with changes to cash are:
Any component of ΔNI (except inventory-related expense) whose corresponding (“other side”)
journal entry could not be ΔCash.
Components of ΔNI in this category include, for example:
 Depreciation Expense.
 PPE Write-Down Expense.
 Loss on Sale.
In each case, the other side of the originating journal entry is never cash.

The effect of Gain on Sale revenue also needs to be backed out of the Income Statement to
obtain Cash Associated Income. This is an exception to the above definition. Details for the
treatment of Gain on Sale transactions are provided in the Appendix to this chapter.

Working Capital Accounts are (as introduced in the Ratio Analysis chapter) defined as follows:
Working Capital Accounts
≡ All Asset and Liability accounts (current and long-term), which are not associated with
financing or investment. IE: All Asset and Liability accounts that are associated with a
firm’s day-to-day business.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 11
Examples of Working Capital Accounts are:
 AR (Accounts Receivable)
 Inventory
 AP (Accounts Payable)
 Pre-paid Expenses (even if non-current)

These are not Working Capital Accounts:

 Short-term portion of Long Term Debt
 Ownership of third-party stock
(unless the firm's business is stock trading)

When recording economic events, care should be taken not to record Investing or Financing
transactions in Working Capital Accounts. For example, say a firm buys a 3-D printer for $5,000
and receives an invoice for the purchase. The entity may record the event as follows:
dr PPE (3D printer) (A)
cr AP (L)
In this case the firm's next Indirect Cash Flow Statement will erroneously show the increase in
AP as an Operating use of cash. To avoid this error, firms typically split AP into two or more
accounts. “AP, Trade” for example, is often used as a Working Capital Account; “AP, Investing”
may be used for recording purchase or sale of small-ish PPE items. Throughout this text, “AP”
is assumed to be a Working Capital Account that contains only Operating items, unless an
exception is specifically identified.

In a given accounting period, a Source of cash from the Working Capital accounts is an increase
in a Working Capital liability or a decrease in a Working Capital asset. Likewise, a Use of cash
from the Working Capital accounts is an increase in a Working Capital asset or a decrease in a
Working Capital liability.

Working Capital and ΔWorking Capital are other useful items that you should probably learn
about now. Working Capital is derived from a firm's Working Capital Accounts and is defined as
follows:
Working Capital
≡ Working Capital Assets – Working Capital Liabilities
Working Capital is a measure of an entity's cash and how much cash entity's operations should
convert to cash, minus how much the entity's operations will have to pay out in cash. For a
healthy company, Working Capital should generally be greater than zero.

ΔWorking Capital is the change to an entity’s Working Capital in an accounting period:

ΔWorking Capital
≡ ΔWorking Capital Assets – ΔWorking Capital Liabilities

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 12
INDIRECT CASH FLOW EXAMPLE 1:
OPERATING CASH FLOW FOR SMALLCO
Consider the Transaction Table and associated notes for SmallCo's 20X1 economic events:

Notes:
1. The AP (PPE) in event eight was created by the PPE vendor’s issuance of an invoice. Since
the AP was generated from the obtainment of PPE, it is considered an Investing source of
cash.
2. More generally:
• Invoices/AP (and Notes) created in exchange for long-term assets, such as PPE or
patents, are considered Investing sources of cash.
• AP and short-term Notes created in exchange for other day-to-day assets are
Operating sources.
• Notes created in exchange for cash are Financing sources (just like Loans or Bonds).

Find:
Cash flow from Operations via the Pure Indirect Method.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 13
Solution:
First note that ΔCash for the year = $355. Next, create a Direct Method Cash Flow Statement for
the firm, using the cash entry inspection method we've already learned:

Lets also create SmallCo's Income Statement for the year, by working from the ΔEquity entries
in the last column of the Transaction Table:

Now we are ready to determine the Cash Flow from Operations section of SmallCo's Indirect
Cash Flow Statement. The steps are as follows:

A) Re-arrange and expand the terms in the Transaction Table to isolate ΔCash and
highlight ΔNI.
First we transform the Transaction Table columns
from: Δ Assets = Δ Liabilities + Δ Equity
to: Δ Cash = ΔNI - ΔAll Other Assets + ΔLiabilities + Δ PIC + Δ Div a)
Then we compress all the components of ΔNI into single entry: ΔNI = 295 (as shown on
SmallCo's Income Statement). Next we similarly total all changes to cash, leaving
ΔCash Total = 355.

Here is the resulting, adjusted Transaction Table:

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 14
Note that ΔCash is still = to ΔEverything Else. This assures us that the Fundamental Accounting
Equation is still satisfied.

B) Further Re-Arrange the Table to isolate Cash Flow from Operations

Recall that:
Indirect Method Operating Cash Flow ≡ 55h)
Net Income for period (ΔNI)
+/- portions of ΔAll Other Assets and ΔLiabilities from equation a), needed to convert
from ΔNI to “Cash-Associated Income”
+/- Sources/Uses from Working Capital Accounts in equation a).

To isolate and subtotal Operating Cash Flow, we add columns to the Transaction Table for
Cash Associated Income and Changes to Working Capital Accounts. With these modifications,
the Transaction Table looks like this:

Note that I've combined the ΔLiabilities and Other ΔAssets into one column, to keep the Table at
a manageable size. Also, as usual ΔCash is still equal to ΔEverything Else, which ensures that
the Fundamental Accounting Equation is still satisfied.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 15
C) Compute Cash-Associated Income
Now we want to populate the ΔCash-Associated Income column. Recall that:
Cash Associated Income ≡ 42p)
ΔNI less effect of components unassociated with ΔCash,
except for inventory-related expenses.
And components of ΔNI unassociated with ΔCash are those whose “other side” Transaction
Table entries (or journal entries) could not have been a change to cash.

We'll use SmallCo's Income Statement to find components of Net Income that could not have
effected cash:

Lets consider each item shown on the Income Statement:

1) Revenue $500K (A)

Journal entries for this could have been:
dr Cash $500K (A)
cr Revenue $500K (A)
-- or --
dr AR $500K (A)
cr Revenue $500K (A)

Self Testing Tip:

What is the 3rd possible type of Revenue entry?

Clearly, Revenue can always be associated with ΔCash. (IE: The “Other side” of its journal
entry {or Transaction Table entry} entry could be ΔCash). So we will not make any adjustments
to the Revenue component of ΔNI.

2) COGS Expense $50K

As an inventory-related expense, COGS is by definition an item that we do not adjust to compute
Cash Associated Income. {See 42p) above}. We will therefore not make an adjustment to
COGS.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 16
3) Depreciation $25K
The associated journal entry for Depreciation Expense is:
dr Depreciation Expense $25K (L)
cr Accumulated Depreciation $25K (L)
Neither side of this entry could have altered cash. So in this case we must adjust (or “back out”)
the effect of Depreciation Expense.

We do this by moving the other side of the Depreciation Expense Transaction Table entry to the
ΔCash-Associated Income column of the Table.

Here is the Transaction Table shown first with the other side entry (Accumulated Depreciation)
identified, then with this entry moved into the ΔCash-Associated Income column. Notice that
once we have moved the entry, the effect of depreciation is removed from Net Income (ΔNI).
(IE: -25K Depreciation Expense + 25K Accumulated Depreciation = 0).

This re-arrangement of terms is generally called “backing out” or “canceling out” the effect of
non-cash expenses. You should convince yourself that the backing out is algebraically correct,
and that ΔCash is still equal to ΔEverything Else in the second version of the Table.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 17
Now we continue reviewing the components of ΔNI for Cash-Unassociated Items:

4) PPE Write-down Expense $35K

The associated Journal entry for this is:
dr PPE Write-down Expense $35K (L)
cr PPE $35K (A)
As neither side of this entry could have affected cash, the PPE Write-Down Expense must be
canceled to get to Cash Income.

5) Loss on Sale $15K.

This one is a little tricky. From the original Transaction Table (Event 4), we see the asset
account was held at $20K but sold for only $5K. In this case, as in all Loss on Sale entries2, we
break the event into cash and non-cash pieces. Here is how to break-up the event:
Cash part of sale:
dr Cash (or AR) $5K (A)
cr Asset Held for Sale $5K (A)
Non-cash part of sale:
dr Loss on Sale Expense $15K (E)
cr Asset Held for Sale $15K (A)
From this we see that neither side of the “non-cash part” could have affected cash. So we will
back out effect of the non-cash part. (IE: We back out the $15K Loss on Sale amount).

6) Interest $30K
- and -
7) Income Tax $100K
The journal entry associated with the Interest Expense item could be:
dr Interest Expense $30K (L)
cr Cash $30K (A)
As this expense could have affected cash, we will not back it out.
The analysis for Income Tax Expense is similar. This entry is also left unadjusted.
2 See the appendix to this chapter for the treatment of Gain on Sale transactions.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 18
Here is the Transaction Table with all the changes we've made to compute Cash-Associated
Income:

SmallCo's ΔCash Associated Income of $310 measures its Net Income of $235 less the effect of
its non-cash expenses. $310 is not equal to the firm's Cash From Operations, because this
amount does not include the impact of Working Capital Sources and Uses (which we will cover
next).

Note that, of the $20 of Equipment for Sale recorded in ΔLiabilities – ΔOther Assets $15 has
been moved to back out SmallCo's $15 non-cash Loss on Sale. $5 remains in ΔLiabilities –
ΔOther Assets, as shown in red. Also, as usual, after making these adjustments ΔCash is still
equal to ΔEverything Else. This ensures that our algebra is correct.

Now is a good time to remind ourselves that the amount of each item that we moved to create
Cash-Associated Income is equal to the amount of the corresponding non-cash expense on
Smallco’s Income Statement. This knowledge will provide us with a helpful shortcut when
preparing GAAP-Sanctioned Indirect Cash Flow Statements.

Summary of Cash-Associated Income Adjustments:

Common items seen on Income Statements that must be “backed out” of Δ NI to get Cash-
Associated Income include:
 Depreciation
 Amortization
(Essentially depreciation of intangible assets)
 Asset write-downs (except inventory)
 Loss on Sale.3
This is a comprehensive list for problems tackled in this book. You can identify other items to
back out on virtually any Income Statement by asking for each entry “could the associated
journal entry include cash?” If the answer is no, then follow our process above to remove the
impact of the non-cash item.

3 Again, see this chapter’s appendix for the treatment of Gain on Sale transactions.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 19
D) Get Sources and Uses from the Working Capital Accounts
To complete the Operating portion of SmallCo's Indirect Cash Flow Statement, our final task is
to identify and aggregate changes to the firm’s Working Capital Accounts. Recall that Sources of
cash from the Working Capital Accounts are increases in Working Capital liabilities or decreases
in Working Capital assets. Similarly, Working Capital Uses of cash are increases in Working
Capital assets or decreases in Working Capital liabilities. The rigorous algebraic sign convention
we employ throughout the creation of our Cash Flow Statement ensures that Working Capital
Sources will automatically carry a + sign, and Uses will carry a – sign.

To assemble the changes to SmallCo's Working Capital Accounts, we first scan the remaining Δ
Liabilities / Other Δ Assets sections of its Transaction Table to identify ΔWorking Capital
accounts, as shown here with the appropriate accounts printed in red.

Note that the AP (PPE) account is not part of Working Capital, as it was generated by the
purchase of PPE. It is therefore an Investment source, which we will treat later on.

Our last step is to move the ΔWorking Capital accounts to the Changes to Working Capital
Accounts column of the Transaction Table, as shown here:

Now SmallCo's Cash from Operations is equal to the total of the ΔCash Associated Income
column plus the ΔWorking Capital column. (Yahoo!). Note that the total ($400) matches the
amount computed in SmallCo's Direct Method Statement.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 20
E) Put Results in Indirect Cash Flow Statement Format
Here are the components of SmallCo's Operating
Cash Flow, as they will be shown on its complete
Indirect Cash Flow Statement.

For comparison, here is the Operating portion of SmallCo's Direct Method Statement.

Good to Know:
If you are only interested in creating GAAP-Sanctioned Indirect Cash Flow Statements, you can
skip to The GAAP-Sanctioned Indirect Cash Flow Statement section of this chapter, on page 25.

More Good to Know:

The “+/- Changes to Working Capital Accounts” section of SmallCo's Transaction Table can be
alternately presented as “-ΔWorking Capital (except ΔCash).” Here is how and why this works:
Recall that “Working Capital” accounts
≡ All Asset and Liability accounts (whether current or not) that are not associated with financing
or investment.

Consider the Working Capital portions of SmallCo's 20X0 and 20X1 Balance Sheets, the
associated ΔWorking Capital, and the associated Sources and Uses:

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 21
From this we see that the tally of SmallCo's Sources and Uses is indeed equal to -ΔWorking
Capital (except ΔCash) for the firm.

Using -ΔWorking Capital (except ΔCash), we can re-write our definition of Operating Cash
Flow as:
Operating Cash Flow ≡
NI for period (ΔNI)
+/-ΔBalance Sheet amounts needed to convert
from ΔNI to Cash Income
-ΔWorking Capital (except ΔCash)
This form is used in many finance applications (as opposed to pure accounting situations).

HOW TO CREATE A PURE, INDIRECT METHOD

CASH FLOW STATEMENT, CONTINUED

II. Investing and Financing Sections

Creating the Investing and Financing sections of a Pure, Indirect Cash Flow is a straightforward
process. Here are the steps:
A) Work from the Transaction Table used to create Cash Flow from Operations.
B) Scan all the remaining “Other Δ Equity” and “ΔLiabilities - Other ΔAssets.”
Reorganize the entries into Investing and Financing groups.
(As noted above, Sources will automatically carry + signs, and Uses will automatically carry
– signs).
C) Put the resulting data into Pure, Indirect Cash Flow Statement format, along with the
Operating portion of the statement.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 22
INDIRECT CASH FLOW EXAMPLE 2:
INVESTING AND FINANCING CASH FLOW FOR SMALLCO:

To find the Investing and Financing portions of SmallCo's Indirect Cash Flow statement we
follow the steps outlined above:

A) Work from the Transaction Table used to create Cash Flow from Operations.
Here is SmallCo’s 20X1 Transaction Table with completed Operating Cash Flow tabulations:

The first two columns on the right hand side of the equal signs comprise SmallCo's Operating
Cash Flow data (totaling $400). The final two columns contain the firm’s indirect Investing and
Financing Cash Flows (including some non-cash Sources and Uses).

B) Identify all remaining “Other Δ Equity” and “ + ΔLiabilities - Other ΔAssets” items as
either Investing or Financing, and move the items into the appropriate section.
Recall that Investing entries are generated by non-operating investments of a firm’s resources
with 3rd parties. Examples include:
 ΔPPE,
 ΔLoans Receivable,
 ΔInvestment Portfolio

Financing entries are generated by non-operating flows for obtaining or returning cash from or to
a firm’s stakeholders. (Stakeholders as always include shareholders and lenders). Example
entries are:
 ΔLoans/Bonds Payable (principal only).
 Δ Notes from financing transactions,
 Δ PIC,
 ΔDividends.

Here is SmallCo's Transaction Table with all remaining “Other ΔEquity” and “+ ΔLiabilities -
Other ΔAssets” organized into Investing and Financing sections.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 23
C) Put the resulting data into Pure, Indirect Cash Flow Statement format, along with the
Operating portion of the statement.
Here is Smallco's completed Pure, Indirect Cash Flow statement:

For comparison, here is the company's complete Direct Method Statement:

Notice that the Indirect Method Statement includes some non-cash Sources and Uses. Also note
that the Total Cash Flow numbers on each statement are equal, as well as the subtotal Operating,
Investing and Financing amounts. In general, the individual Investing and Financing subtotals
are not guaranteed to match, but the Investing + Financing subtotals will match.

SOURCES AND USES, AND THE INDIRECT CASH FLOW STATEMENT PAGE 24
THE GAAP-SANCTIONED INDIRECT CASH FLOW
STATEMENT
GAAP and “Pure” Indirect Cash Flow Statements are the same except for two things:
1. GAAP renames the items used to compute Cash-Associated Income from ΔNI.
2. GAAP uses the Direct-Method for its Investing and Financing sections.

To see how GAAP statements rename some items, consider the Operating portion of SmallCo's
Pure Cash Flow Statement, and its Income Statement for the same period (20X1):

GAAP replaces the names of the entries we used to compute Cash-Associated Income with the
names of their “other side” entries, as they appear on the Income Statement. So for example,
GAAP statements rename “Accumulated Depreciation” with “Depreciation”.

After renaming the components of Cash-

Associated Income, the Operating portion of
SmallCo's GAAP-style, Indirect Cash Flow
Statement looks like this:

Note that the numerical results of the GAAP and Pure Statements are identical, line-by-line.

When making GAAP-sanctioned Indirect Cash Flow Statements, some practitioners say they
“add back” non-cash-related expenses to Net Income to compute cash-associated income. As
shown above this is not strictly correct, but it provides a nice way to remember how we convert
Net Income to cash-associated income.

The second (and final) change that GAAP makes to a Pure Statement is, as noted above, is the
use of Direct Method Investing and Financing Sections. Incorporating these modifications and
the above renaming changes into the Pure Statement gives us the completed GAAP-Sanctioned
Indirect Cash Flow Statement:

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 25
Going forward, we will typically use the GAAP-sanctioned version of the Indirect Statement.

SUMMARY:
HOW TO CREATE GAAP-METHOD INDIRECT CASH
FLOW STATEMENT
Here are the steps needed to create a GAAP-Basis, Indirect Cash Flow Statement (CFS):
1. Assemble a Transaction Table or set of journal entries for the period.
2. Create a Direct Method Cash Flow Statement and Income Statement (IS).
3. Compute the Operating Cash Flow Section of the CFS.
(Recall that OCF = Cash-Associated Income + ΔWorking Capital).
a) Create Cash-Associated Income from the Income Statement. Start with Net Income and
back-out the effect of all non-cash Income Statement items. Recall that the amount of
each add-back item is equal to the corresponding amount shown in the Income
Statement. Using this knowledge, simply add-back the non-cash amounts on the
Income Statement and label them as described on the Statement. (You do not need to
refer to a Transaction Table or journal entries for this step).
b) Identify all changes to Working Capital Accounts in your Transaction Table or journal
entries. Assemble these sources and uses into the “Changes to Working Capital
Accounts” portion of the Indirect Cash Flow Statement. (Remember that Sources get a
+ sign and Uses get a – sign).
c) Check that your Operating Cash Flow subtotal is the same as shown on your Direct
Method Statement.
4. Add the Investing and Financing sections from your Direct Method Cash Flow Statement.
5. Organize your results into Indirect Cash Flow Statement format, and double check that all
your totals are same as the corresponding amounts on your Direct Method Statement.

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 26
This example follows these steps.

INDIRECT CASH FLOW EXAMPLE 3:

PURE INDIRECT CASH FLOW STATEMENT FOR APO:
Given following for APO during the year 20X1:
 Economic events4
 Transaction Table
 Income Statement
 Direct Method Cash Flow Statement
Compute a GAAP-Sanctioned, Indirect-Method Cash Flow Statement for the year. Check your
Cash Flow from Operations against the Direct Method Statement.

Economic events for 20X1 ($MM):

1. APO purchased inventory (homes) costing $34,000 on account.
(IE: was invoiced at time of purchase).
2. Sold/invoiced $37,000 of homes to customers (APO ‘matches’ certain expenses to revenue
at the end of each accounting period, rather than with each sale).
3. Received $1,000 in cash prepayment for services it promises to deliver in 20X2.
4. Noted that its Cost of Goods Sold was $30,000.
5. Received $33,000 in payments on previously-submitted invoices.
6. Paid $29,000 of outstanding vendor invoices.
7. Noted need to pay and paid $5,000 to rent office space for the year and for other
administrative costs.
8. Prepaid $3,000 for 20X2 office space rent.
9. Noted depreciation on all its PPE assets.
10. Noted and paid 20X1 interest on its Loan Payable.
11. Noted $1,000 of inventory was destroyed and useless as inventory but retained 500 in
salvage value.
12. NA.
13. Sold all its ‘Equipment Held for Sale’ for $700 cash.
14. Estimated (noted) its 20X1 taxes at $147.
15. Paid its owners a dividend of $100.

4 These are the same as given in Chapter 6 except that the buyout of BabyRealty is omitted. (IE: Event 12 is
omitted).

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 27
Transaction Table for the above events:

20X1 Income Statement:

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 28
 20X1 Direct-Method Cash Flow
Statement ($MM)

Solution:
Here is the Transaction Table, algebraically modified with Δ Cash on the left hand side, Δ All
Other Assets moved to the Right hand side. Also, Revenue and Expenses have been condensed
into Net Income, Δ Equipment Held for Sale has been broken into its cash and non-cash parts,
and all entries have been sorted by account.

We obtain a complete, Pure Indirect Cash flow statement from this by re-arranging terms and
subtotaling by account as show below:

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 29
The steps we used to morph the adjusted Transaction Table to the Pure Indirect CFS are as
follows:

– Create an empty Indirect CFS Table:

– Put NI in top position of OCF column.

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 30
– Compute Cash-Associated Income by backing-out the non-cash, non-Inventory items on APO’s
Income Statement.
The left-side figure below figure shows APO’s income statement with non-cash items in
yellow. The right-side figure is APO’s adjusted Transaction Table with the associated non-
cash, non-Inventory items shown in blue. (“Associated” items are simply “other side”
transaction table entries).

– Add changes in Working Cap Accounts below Cash-Assoc-Income:

In the adjusted Transaction Table above, changes to the Working Capiatal accounts are
highlighted in red. Note also that:
◦ Accounts are subtotaled before being recorded in the Cash Flow Statement table.
◦ The change in “Misc Asset” of -$0.50 is a Working Capital Use, because the asset
came out of Inventory. (Inventory Write-Downs are considered part of industrial
companies’ normal business operations).
◦ The cash part of “Equipment Held for Sale” (+$0.7) is not a Working Capital source,
because asset came out of PPE.

– Check that the total Cash Flow from Operations is the same as the total shown on the
Direct Method Statement.

– Put the remaining Adjusted Transaction Table entries into the Investing Cash Flow or
Financing Cash Flow sections of the Cash Flow Statement table, using our usual rules for
distinguishing between investing and financing flows.

With these steps completed, APO’s Pure Indirect Cash Flow statement looks like this (the same
as above):

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 31
INDIRECT CASH FLOW EXAMPLE 4:
GAAP-BASIS INDIRECT CASH FLOW STATEMENT FOR APO:
We start creating the GAAP-Basis statement by adopting the same given information that we
used in the previous example. The solution steps for this case are then as follows:

 Use the Pure, Operating Cash Flow section created above, except replace the names of the
Cash Associated Income adjustments to their “other side” names, as seen on the Income
Statement. With this change, Cash-Associated Income looks like this:
Net Income (NI) $0.27
+ Depreciation (renamed from Accum. Depreciation) $0.50
+ Loss on sale (renamed from Equip held for Sale) $0.30
= Cash-Associated Income $1.07

Note that, as discussed above, the Cash-Associated Income adjustments are numerically equal to
the amounts shown on the Income Statement.

With these changes, the GAAP - Basis Operating Cash Flow section reads like this:

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 32
Cash Flow From Operations (Switching back to $MM from $BB):
Net Income (NI) $273
+ Depreciation $500
+ Loss on sale $300
= Cash-Associated Income $1,073

+/- Changes to Working Capital Accounts:

AR -$4,000
Inventory -$3,000
Misc. Assets -$500
Prepaid Rent -$3,000
AP $5,000
Accrued Tax $147
Unearned Revenue $1,000
= Cash From Operations -$3,280

 Check that the subtotal for OCF is same as shown on our Direct Method statement.
In this case, the above total Cash From Operations is the same as shown in the Direct
Method Statement above.

 Add the Investing and Financing sections from your Direct Method Cash Flow Statement.

 Put the entire result into Indirect Cash Flow Statement format, and double check that the
total cash flow matches the total on the Direct Method Statement.

With all these steps completed, here is APO's entire GAAP-basis Indirect Statement:

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 33
As shown, Indirect Cash Flow Statement format includes presentation of the firm's EOP and
BOP cash balances. We took the BOP balance from the given direct-method cash flow
statement. Normally, the BOP cash balance would be taken from the entity's BOP Balance
Sheet, which is unavailable for this example. Also, the EOP cash balance should be checked
against the firm's EOP Balance Sheet, which has not been provided for this problem.

For comparison purposes, here again is APO's Direct Method Cash Flow Statement for 20X1.
The Total Cash Flow and subtotals for Operating, Investing and Financing all match the Indirect
Statement numbers, as they must.

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 34
 APPENDIX
INDIRECT CASH FLOW TREATMENT OF GAIN
ON SALE TRANSACTIONS

SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 35
SOURCES AND USES , AND THE INDIRECT CASH FLOW STATEMENT PAGE 36
AFTERWORD

CHAPTER 15
 YOU'VE ONLY JUST BEGUN...
If you are still reading at this point you should congratulate yourself on mastering the
fundamentals of the accounting language, and for getting a glimpse of how useful the language
can be. You should be happy that your knowledge of accounting is better than almost everyone
else's (if you consider the entire population of the world), including that of many Wall Street
analysts.

As scintillating as accounting is in its own right1, it gets even more exciting when applied to
problems in corporate and public finance. We've seen examples of this in our ratio analysis
studies and our analysis of Fannie Mae's collapse. To learn more great applications of
accounting you need to know more about Finance. To get started, I recommend (in self-serving
order):
 Introduction to Business Finance. Anthony Webster.
 Corporate Finance. Ivo Welch.
 Analysis for Financial Management. Robert Higgens.
 Fundamentals of Corporate Finance. Richard Brealey, Stewart Myers and Alan Marcus.

As you learn finance, you will find that more accounting knowledge is helpful, and in some cases
necessary (as with, for example, the study of tax-deferred assets and LIFO/FIFO inventory). To
paraphrase Wallis Simpson, the former Duchess of Windsor, 'you can't be too rich, too thin, or
know too much accounting.' With this in mind, here are a couple of suggestions for further
study:
 Financial Accounting. Larry Walther.
 Intermediate Accounting. Donald Kieso, Jerry Weygandt, and Terry Warfield.

For anyone considering a career in accounting or finance, its extremely important to keep
current. To achieve this, I suggest reading every accounting, finance and economics article you
can find in The Wall Street Journal, The Financial Times, Barrons and The Economist. I also
strongly reccomend listening to Bloomberg radio, which provides more in-depth interviews with
Nobel Laureates, brilliant economists, and world-class investors than any other media outlet I've
found.

Finally, I hope that you've learned some useful and interesting things in this text. Feel free to
send comments and queries – good, bad and ugly – to me at [email protected].

1 Just kidding.

CHAPTER 15 – AFTERWORD PAGE 2