WALL STREET PREP: ACCOUNTING CRASH COURSE

QUESTIONS AND CORRECT VERIFIED ANSWERS

What is Accounting?
Accounting is the language of business; it is a standard set of rules for measuring a
company's financial performance.
Assessing a company's financial performance is important for:
The firm's officers (managers and employees)
Investors
Lenders
General public
Standard financial statements serve as a "yardstick" of communicating financial
performance to the general public.
Why is Accounting Important?
Enables managers to make corporate decisions
Enables the general public to make investment decisions
Who Uses Accounting?
Used by a variety of organizations - from the federal government to non-profit
organizations to small businesses to corporations
We will discuss accounting rules as they pertain to publicly-traded companies
Accounting Regulations
Accounting attempts to standardize financial information and follows rules and
regulations
These rules are called Generally Accepted Accounting Principles (GAAP)
In the US, the Securities and Exchange Commision (SEC) authorizes the Financial
Accounting Standards Board (FASB) to determine accounting rules
GAAP comes from the Statements of Financial Accounting Standards (SFAS) issued by
the FASB
An Overview of the SEC
A US federal agency established by the US Congress in 1934
Primary mission is "to protect investors and maintain the integrity of the securities
markets"
Division of Corporate Finance oversees FASB
An Overview of FASB
Established in 1973 as an independent body to carry out the function of codifying
accounting standards on the behalf of the SEC
Composed of seven full-time members appointed for five years by the Financial Account
Foundation (FAF)
Decisions are influenced by:
International Financial Reporting Standards (IFRS)
Over 100 countries, including the EU, UK, Canada, Australia, and Russia, have adopted
a unified set of international accounting standards (IFRS)
Although we have seen unprecedented convergence over the last few years between
US GAAP and IFRS, some differences remain
Assumption 1: Accounting Entity
A company is considered a separate "living" enterprise, apart from its owners
In other words, a corporation is a "fictional" being
Assumption 2: Going Concern
A company is considered a "going concern" for the foreseeable future; it is assumed to
remain in existence indefinitely
Assumption 3: Measurement
Financial statements can only show measurable activities of a corporation such as its
quantifiable resources, its liability, amount of taxes it is facing, etc.
Assumption 4: Periodicity
Companies are required to file annual and interim reports
In the US, quarterly and annual financial reports are required
An accounting year (fiscal year) is frequently aligned with the calendar year
Four Underlying Assumptions of Accounting
(1) Accounting Entity
(2) Going Concern
(3) Measurement
(4) Periodicity
Principle 1: Historical Cost
Financial statements report companies' resources at an initial historical cost
Why?
Represents the easiest measurement method without a need for appraisal and
revaluation
Marking resources up to fair value allows for management discretion and subjectivity,
which US GAAP attempts to minimize by using historical cost
Note: IFRS allows you to write up the asset to fair value, but most companies use
historical value anyways
Principles 2 and 3: Accrual Accounting (Revenue Recognition and Matching
Principle)
Governs the company's timing in recording its revenues (i.e. sales) and associated
expenses
2) Revenue Recognition: Accrual basis of accounting dictates that revenues must be
recorded when earned and measurable
3) Matching Principle: Under the matching principle, costs associated with making a
product must be recorded during the same period as revenue generated from that
product
Exercise Answer: 1) 1/4/15; 2) 1/4/15
Why can't companies immediately record these revenues and expenses?
According to the revenue recognition principle, a company cannot record revenue until
that order is shipped to a customer (only then, is the revenue actually earned) and
collection from that customer is reasonably assured
Why shouldn't a company record an expense when it actually buys the item?
According to the matching principle, costs associated with the production of the product
should be recorded in the same period as the revenue from the product's sale
US GAAP vs. IFRS Accrual Accounting
Principle 4: Full Disclosure
Companies must reveal all relevant economic information that they determine to make a
difference to its users
Such disclosure should be accomplished in the following sections of companies' reports:
(1) Financial statements
(2) Notes to financial statements
(3) Supplementary information
Four Underlying Principles in Accounting
(1) Historical Cost
(2) Accrual Accounting: Revenue Recognition
(3) Accrual Accounting: Matching Principle
(4) Full Disclosure
Constraint 1: Estimates & Judgments
Certain measurements cannot be performed completely accurately, and must therefore
utilize conservative estimates and judgments
Constraint 2: Materiality
Inclusion and disclosure of financial transactions in financial statements hinge on their
size and effect on the company performing them
Note: Materiality varies across different entities
Constraint 3: Consistency
Each company has to prepare financial statements using measurement techniques and
assumptions which are consistent from one period to another
Constraint 4: Conservatism
Financial statements should be prepared with a downward measurement bias
Assets and revenues should not be overstated, while liabilities and expenses should not
be understated
Four Underlying Constraints in Accounting
(1) Estimates & judgments
(2) Materiality
(3) Consistency
(4) Conservatism
Summary of Accounting Assumptions, Principles, Constraints
Most important are the historical cost, revenue recognition, and matching principles
Financial Reporting Overview
Presented in the companies' financial reports and standardized by accounting
Companies must file periodic financial reports with the SEC
Finding Financial Reports
On the sec.gov website
UK: companieshoues.gov.uk
Canada: sedar.com
Also, company websites and financial websites and services
Form 10-K (Annual Filing)
Publicly traded companies must file the 10-K at the end of each fiscal year
Includes a thorough overview of their businesses and finances, as well as their financial
statements
Must be filed within 60-90 days within year end, depending on filer's status (large
accelerated (60)/accelerated/non-accelerated filer (90))
Why is the 10-K important?
Required annual filing that provides the most detailed overview of companies' financial
operations and regulations governing them
Annual Report vs. 10-K
Form 10-Q (Quarterly)
At the end of each quarter of their fiscal year (for the first three quarters), publicly-traded
companies file a report with the SEC which includes financial statements and non-
financial data
Must be filed within 40-45 days of quarter end
10-K vs. 10-Q
Form 8-K
A required filing any time a company undergoes or announces a materially significant
event such as an earnings press release
Usually filed within 4 days of the event
Form 14A (Proxy Statement)
A required filing prior to a company's annual shareholder meeting
Contains detailed information about top officers and their compensations
Often solicits shareholder votes (proxies) for Board nominees and other important
matters
Other Financial Reports
S-1, S-4, and 20-F
Part 1 of the 10-K
Part 2 of the 10-K
The red meat of the 10-K
Parts 3 and 4 of the 10-K
Where can you find the latest share count on a 10-K?
At the bottom of the cover page
Business Section of the 10-K
Allows you to get to know a company
Generally Includes: Company background, business strategy, product descriptions,
markets and distribution, competition, distribution networks
MD&A Section of the 10-K (Item 7)
Reviews what happened during the year, what their expectations are, etc.
Selected Financial Data of the 10-K (Item 6)
Includes the most important financial highlights
Financial Statements Section of the 10-K (Item 8)
Includes: B/S, CFS, I/S, etc.
T/F: GAAP requires that firms show recorded values for acquired intangible
assets such as patents and trademarks on their financial statements
True!
GAAP requires that firms only show measurable activities, such as the value of acquired
intangible assets
Assets such as employee, customer loyalty, and internally-developed trademarks are
not shown on financial statements
The Income Statement is designed to measure...
The profits of a firm over a period of time
What is the Income Statement?
A financial report that depicts the operating performance of a company (i.e. revenues
less expenses generated or profitability) over a specific period of time (quarter or year)
AKA The Consolidated Statement of Earnings, Profit and Loss Statement (P&L),
Statement of Revenues and Expenses
Why is the Income Statement Important?
Facilitates the analysis of a company's growth prospects, cost structure, and profitability
Analysts use it to identify the components and sources ("drivers") of net earnings
Major Income Statement Line Items (Pt. I)
Major Income Statement Line Items (Pt. II)
Ways to Measure Profitability
EBITDA & Operating Profit (EBIT)
Bottom Line
Net income on the Income Statement
Revenue
Represents proceeds from the sale of goods and services produced or offered by a
company
Not all income is revenue
Interest income earned from investments and income received from a legal settlement
are not considered revenue
AKA Sales, turnover, net sales, net revenues, top line
Top Line
Revenues on the Income Statement
CVS Revenue Exercise
Note: How much you collect in cash is irrelevant in revenue; it is how much you
EARNED during the period
Revenue Recognition
Accrual accounting dictates that revenue must be recorded only when it is earned and
measurable
In other words, until an order is shipped to a customer and collection from that customer
is reasonably assured
Revenue Recognition: Multiple Deliverables
For sales of bundled products, companies should assign individual values to each of the
bundled components
This is especially relevant in the software industry (see picture)
Revenue Recognition: Long-Term Projects
Companies have some flexibility with long-term project revenue recognition
(1) Percentage of Completion Method: Revenues are recognized on the basis of the
percentage of total work completed during the accounting period
(2) Completed Contract Method: Rarely used in the US; allows revenue recognition
only once the entire project has been completed
Matching Principle
Expenses should be "matched" to revenues
The costs of manufacturing a product are matched to the revenue generated from that
product during the same period
Accrual Accounting
Revenues are recognized and recorded when an economic exchange occurs, while
expenses are recognized when the associated revenues are recognized, not
necessarily when cash is exchanged
What would happen if we recognized expenses when they are incurred like
revenue?
Shows an inaccurate depiction of a company's profitability
Accrual vs. Cash Accounting
Although the benefits of the accrual method are apparent, it has the limitation that
analysts cannot track objectively the movement of cash
The cash flow statement allows analysts to reconcile these differences
Cash accounting is more objective; accrual accounting is more subjective
Cash Accounting
Not allowed under GAAP but used for tax reporting for certain businesses
Objectively recognizes revenues when cash is received and records costs when cash is
paid out
Revenue Manipulation
Because of accrual accounting, revenue recognition can be subjective
This "wiggle room" creates potential for manipulation in the form of shifting revenues
from one period to another
While revenue recognition methods are almost always explained in companies' 10K
footnotes, when there is suspicion of "shenanigans," these should be read carefully
Cost of Goods Sold / Cost of Sales
A company's direct cost of manufacture (for manufacturers) or procurement (for
merchandisers) of a good or service that the company sells to generate revenue
COGS do not include administrative costs such as corporate overhead, marketing
and administrative expenses, R&D, and salaries of employees (included under Selling,
General, & Administrative Expenses or other line items)
For a Manufacturer Inventory, direct labor, factory overhead (indirect costs), shipping &
delivery costs
For a Merchandiser Inventory, shipping & delivery costs
For a Service Provider Direct service costs
COGS Exercise
Cashiers and management offices are a part of SG&A expenses
R&D is its own line item
Gross Profit
Represents profit after only direct expenses (COGS) have been accounted for:
Gross Profit = Net Revenues – COGS
In Exercise: $100M in revenues - $40M in inventories used up – $2M in shipping =
$58M (Remember the matching principle!)
Selling, General, & Administrative Expenses
Operating expenses that are not included in cost of goods sold are allocated to
categories titled 'Selling, general & administrative expenses' (SG&A) but may also
include terms like marketing and operating expenses in the title
Represents the operating expenses not directly associated with the production or
procurement of the product or service that the company sells to generate revenue
SG&A Exercise
Research & Development (R&D)
R&D expenses stem from a company's activities that are directed at developing new
products or procedures
Research-intensive industries like healthcare, energy, and technology often identify
R&D expenses separately because they are so large; other companies aggregate R&D
expenses within Other Operating Expenses or SG&A
Includes: Compensation for employees, equipment, and facilities engaged in the R&D
process
Depreciation Expense
Accrual accounting dictates that we spread the cost of an asset evenly over the useful
life of the asset so that costs are matched to the period when revenue is earned as a
result of using the asset
The resulting annual expense is called depreciation
Quantifies the wear and tear from the use and passage of time of the physical asset
through a systematic decrease of the assets' book (historical) value
Depreciation Exercise
Where is depreciation expense on the Income Statement?
You will not see a line item on the I/S specifically identifying depreciation expense
Depreciation is included within COGS (asset is directly tied with manufacture or
procurement) or SG&A (asset is not directly tied, like selling or marketing)
Note: You can find depreciation expense identified separately on the cash flow
statement
Depreciation Expense is a Non-Cash Expense
Depreciation is a non-cash expense and can make up a significant portion of total
expenses on a company's income statement
That makes the income statement a poor tool for tracking a company's cash position --
I/S profits are reduced each year by depreciation, whereas actual cash profits are
affected only when cash payments for purchases of assets are made
Straight Line Depreciation Method
Under US GAAP and IFRS, most companies choose to depreciate assets evenly over
their useful lives
Under this method, the depreciable cost of an asset is spread evenly over the asset's
estimated useful life
Annual depreciation expense = (Original cost – salvage value) / Useful life
Original Cost = Original cost of the asset
Salvage (Residual) Value = The asset's estiamted salvage at the time of disposal
Depreciable Cost = Original cost – Salvage value
Useful Life = Total years the asset is expected to remain in service
Balance Sheet & Depreciation
The balance sheet tracks the book value of a depreciable asset and the accumulated
depreciation
The ending book value is simply the salvage value, and it sits there until the asset is
sold or retired
Accelerated Depreciation Method
Methods that calculate a greater amount of depreciation in earlier years than later years
Common Methods:
Declining balance
Sum of years digits
Units of production
Why do companies prefer straight line depreciation?
Amortization Expense
The allocation of the cost of intangible assets over the number of years that these
assets are expected to help generate revenue for the company
Conceptually similar to depreciation and often lumped in with depreciation as
Depreciation & Amortization
Like with fixed assets, when a company purchases an intangible asset from which it
expects to generate benefits over future periods, the cost of the asset is spread over
that particular asset's useful life in the form of amortization expense
Note: Trademarks and goodwill are not amortized
Amortization is a Non-Cash Expense
Amortization does not depict any actual cash outflow (payment), like depreciation
The only difference between depreciation and amortization is that depreciation refers to
fixed assets, while amortization refers to acquired intangible assets
Internally-Generated Intangible Assets
Expenses associated with internally developing intangible assets like patents, customer
lists, trademarks are expensed fully as they are incurred (no amortization)
Since companies are not allowed to write up the value of intangible assets (historical
cost and conservatism), companies with very valuable trademarks and patents (Coke,
GE, Apple) do not recognize or amortize these assets
Intangible assets on the balance sheet that are amortized are mostly acquired assets
Amortization & Depreciation Exercise
Salaries are NOT depreciated!
Trademarks that are ACQUIRED are never expensed, like land
Expense of Employee Salaries
The expense of employee salaries are embedded within the expense categories based
on the employee's job function
A corporate manger or sale person's salary will be in SG&A
The salary of a software engineer will be in R&D
The salary of a factory supervisor at a tire manufacturer will be in COGS
Stock Based Compensation Expense
When a company compensates an employee with stock (like stock options or restricted
stock), the value of that compensation is recognized as an expense in the same
expense category as the employee's regular cash compensation during the period that
that stock based compensation is actually earned
Even though its recognized as an expense as an employee earns the SBC, remember
that SBC is a non-cash form of compensation
Note: Valuing stock based compensation is very difficult
Where is SBC on the Income Statement?
Just like depreciation, you won't see a line item on the I/S specifically identifying SBC
expense
It is included within the operating expenses in which the employee is classified
However, like depreciation, you will almost always find SBC expense identified
separately on the cash flow statement
Other Operating Expenses/Income
Companies will sometimes recognize expenses (or income) on the I/S that, while still
related to operating activities, are a little less typical
Includes: Gains/losses on sale of fixed assets, gains/losses from a legal settlement,
restructuring expenses and severance costs, losses due to inventory spoilage
(inventory write-down)
On the I/S: They will often be embedded within larger operating expense categories like
SG&A, or in a separate line item called "Other operating expenses"
Companies sometimes provide a separate disclosure in their press releases where they
have more freedom to detail these items (non-GAAP reconciliation)
When the expense (or income) is large, it may be identified as its own separate line item
Non Operating Income and Expenses
Everything below operating profit is not directly related to the operations of the business
Above vs. Below the Line
Above the Line: Everything above Operating Income on the I/S that's tied to the core
operations of a business
Below the Line: Everything below Operating Income
Interest Expense
Payments the company makes for its outstanding debt
Corporations make regular interest payments on debt owed to banks or other lenders
Interest Income
A company's income from its cash holdings and investments (stocks, bonds, and
savings accounts)
Net Interest Expense
Sometimes, interest income and expense are netted against one another when
presented on the I/S
Other Non-Operating Income / Expenses
INCOME
Companies may generate income from non-operating activities:
Increases in value and gains on sale on certain financial investments
EXPENSES
Represents expenses that are not tied to the core operations of the business or are
unusual:
Decreases in value and losses on sale on certain investments and debt, currency
exchange losses
Non-Operating Income and Expenses are often netted together on the I/S
Tax Expense
Under US GAAP and IFRS, companies report tax expense as a separate line item
usually right below a line item called 'Pretax Income' or 'Income before provision for
income taxes'
Tax expense doesn't equal the actual cash taxes paid!
Because of the ability of companies to defer certain taxes, the tax expense recognized
on the I/S does not equal actual cash taxes they have to pay for the same period
Net Income
The final measure of profitability on the on the I/S
Represents income after all expenses have been paid out
AKA Net earnings, net profit, bottom line
Shares Outstanding
Represent the number of shares of common stock outstanding
One share of common stock represents one unit of ownership of a public company
Shareholders are generally entitled to vote on the selection of directors and other
matters and to receive dividends in proportion to the number of shares they own
Shares Outstanding = Shares Issued – Treasury Stock
Treasury Stock
Shares that have been issued but subsequently repurchased by the company; they are
no longer outstanding
Why Repurchase Stock? Boost EPS (repurchase of shares reduces total shares
outstanding) or change the company's capital structure (more debt/less equity)
What Happens? The company either goes into the open market and buys the shares at
the current share price, or through negotiation with specific shareholders
Impact on Share Count: Basic shares outstanding are reduced; Basic shares
outstanding = Total shares issued less shares repurchased
Note: Treasury stock is a contra equity account to capture the value of common stock
that was once issued but then repurchased by the company
Shares Outstanding - Basic vs. Diluted
Basic includes only the actual shareholders
Diluted includes the impact of potentially dilutive security holders that expand the share
base, like stock option holders and preferred shareholders that can convert their
preferred shares to common stock
Dilutive Securities
Securities that can be converted into common stock
Includes: Stock options & warrants (the right to buy shares at predetermined price);
convertible preferred stock; convertible debt
Earnings Per Share (EPS)
Common way to analyze profits by dividing net income by shares outstanding
Measures how much of the total current period profits belong to each shareholder
Types:
Basic EPS = (Net income) / (Basic shares outstanding)
Diluted EPS = (Net income) / (Diluted shares outstanding)
Note: Since diluted shares include all these other securities, diluted EPS will almost
always be smaller than basic EPS
Diluted EPS is the favored approach because it is more economically "real"
Weighted Average Presentation of Shares Outstanding
Since the total number of shares outstanding fluctuates, companies usually show the
number of shares outstanding on the I/S as weighted average of the amount of shares
outstanding during the period of the I/S
Common Dividends
Represent a portion of the company's net income that is returned to shareholders,
typically on a quarterly basis, in the form of cash
Dividend policy is set by the Board of Directors, is reviewed regularly, and is disclosed
in the company's financial statements
What can companies do with profits?
Distribute dividends
Reinvest in the business through new purchases, acquisition, etc.
Pay down existing debt obligations or other liabilities
Sit on it (grow a pile of cash)
Dividend Presentation on the I/S
Common dividends are usually presented below net income and EPS on an income
statement
Earnings Before Interest and Taxes (EBIT)
Analysts often use operating income or EBIT to compare the performances of
businesses
Earnings Before Interest and Taxes, Depreciation, & Amortization (EBITDA)
An even more popular metric than EBIT for analyzing companies
Why?
(1) D&A is a huge noncash expense for fixed asset and intangible asset intensive
businesses, and stripping out the biggest noncash expense provides a more accurate
picture of "real" profits during the year
(2) Since companies can use different useful life assumptions and even depreciation
methods to calculate D&A this can skew the comparison of operating profitability
Where is it? SInce D&A is not usually disclosed on the I/S, analysts have to go to the
CFS to get D&A and add it back to EBIT
Note: EBITDA is a blend of accrual and cash accounting. So be careful - it is not a
perfect proxy for operating cash flows
Income Statement Summary
Legal Expenses
While losses or gains from legal settlements are classified as non-operating expenses,
regular recurring legal expenses are classified as an operating expense within SG&A
Operating Income
Operating Income = Net Revenue - COGS - SG&A - Other Operating Expenses
Is revenue recognized at the time of delivery of goods and services, regardless of
when the cash is received?
Yes!
Gross Profit Margin
Gross Profit / Net Sales (Revenue)
The higher the margin, the better a company is at converting revenue into profits
The Balance Sheet
Reports the company's resources (assets) and how these resources were funded
(liabilities and shareholders' equity) on a particular date and time (end of the quarter or
year)
Fundamental Equation: Assets = Liabilities + Equity
Historical Cost + Conservatism: The balance sheet does not report the true market
value of a company - only its resources and funding at their historical cost
Assets
Represent the company's resources
Qualifications:
(1) A company must own the resource
(2) The resource must be valuable
(3) The resource must have a quantifiable, measurable cost
Marketable Securities / Short-Term Investments
Debt or equity securities held by the company that provide interest payments
Accounts Receivable (A/R)
Payment owed to a business by its customers for products and services already
delivered to them
Sales that a company has made on credit
Ex. Insurance companies resulting from pharmacy sales; banks for customer credit card
transfers that take in excess of seven days to process
Linked to revenues on the I/S
Inventories
Any unfinished or finished goods that are waiting to be sold and the direct
costs associated with the production fo these goods
Assets Exercise
Note: Internally generated intangible assets are NOT considered assets on the B/S
Liabilities & Equity
Represent the company's sources of funds (how it pays for assets)
Liabilities: What the company owes to others
(1) They must be measurable
(2) Their occurrence is probable
Equity: Sources of funds through...
(1) Equity investment
(2) Retained earnings (what the company has earned through operations since its
inception)
Accounts Payable (A/P)
A company's obligations to suppliers for services and products already purchased for
them, but which have not been paid (unpaid bills for services obtained on credit from
them)
Current liability
Note: No cash is used in the purchase of the inventory
Accrued Expenses
Expenses like employee compensation that the company has incurred, but for which it
has not yet paid
Ex. Year-end bonus, earned wages owed to employees, insurance, rents, taxes,
dividends, litigation costs, etc.
Note: A company must recognize expenses on the I/S when the resources provided by
those expenses were provided, not when the expense is due
Short Term vs. Long Term Debt
Short Term Due within 12 months
Long Term Due more than 1 year
Preferred Stock
Stock that takes priority over common stock and has special rights (priority over
dividends and claims on assets in bankruptcy)
Often structured to include the possibility of conversion into common stock at a pre-set
exchange rate, enabling investors to benefit from a set dividend, but participate in the
upside if the company's common equity value increases
Retained Earnings
Total company earnings / losses since its inceptions less all dividends
Remember: The I/S is connected to the B/S through RE
All income on the I/S increases retained earnings on the balance sheet (credits)
All expenses on the I/S decrease retained earnings (debits)
In addition, all common and preferred dividends decrease retained earnings (debits)
Conceptually, RE represents the cumulative earnings that have been "retained" by the
business, after taking into account all the dividend payments ever made
Liabilities Exercise
Remember: The occurrence has to be probable and the impact must be measurable
Dividends are not liabilities
The Accounting Equation
Every transaction can be viewed as having two sides -- the source of funds, and the
way the funds were used (use of funds)
It is because of this equivalence sources and uses of funds that assets will always
equal liabilities and equity by definition
Double Entry Accounting
Records the two sides of every economic event - 1) The funding source; 2) How the
funds are used
Every transaction is recorded through the use of a "credit" (source of funds) and an
offsetting "debit" (use of funds) such that total debits always equal total credits in value
Double-entry accounting is depicted through the use of a "T account" to track each
source and use of funds in a transaction
Debit: Increases in assets, decreases in liabilities & equity - left side of T account
Credit: Increases in liabilities & equity, decreases in assets - right side of T account
Why is Double-Entry Accounting Important?
It facilitates understanding of the relationship between assets (resources) and
liabilities/shareholders' equity (funding) of a company
The I/S, B/S, and CFS are connected; the relationship among these three statements
and their impact on one another can be initially "illustrated" through debits and credits
Income Statement and Balance Sheet Connections
The I/S is linked to the B/S via retained earnings in shareholders' equity
All income on the I/S (revenue, interest income, etc.) increases retained earnings on
the balance sheet (credits)
All expenses on the I/S (COGS, SG&A, tax, etc.) decrease retained earnings (debits)
Income Statement Impact on the B/S: Revenue
If paid collected entirely in cash
Increase cash (assets)
Increased retained earnings (equity)
Income Statement Impact on the B/S: COGS
Decrease retained earnings (Equity)
Decrease cash, PP&E - depreciation, inventory (Assets)
Income Statement Impact on the B/S: SG&A
Decrease retained earnings (Equity)
Decrease inventory, cash, PP&E - depreciation (Assets)
Income Statement Impact on the B/S: Net Interest Expense
(1) Interest Expense: Reduced retained earnings (equity) and cash (assets)
(2) Interest Income: Increases retained earnings (equity) and cash (assets)
Note: There was no impact to debt from the payment of cash interest - debt level stays
the same
Income Statement Impact on the B/S: Non-Operating Expenses
Retained earnings decreases (Equity)
Cash decreases (Assets)
Income Statement Impact on the B/S: Tax Expense
Retained earnings decreases (Equity)
Cash decreases (Assets)
Changes on the B/S that Don't Affect Retained Earnings
Raising money from investors: Cash increases, common equity increases
Assets Presentation
Assets are presented in descending order of liquidity
Cash is the most liquid asset - always first
Usually followed by A/R and inventory - can be sold quickly
Less liquid assets like PP&E and intangible assets are at the bottom
Current Assets: Assets that can be converted to cash within 12 months; usually listed
first on the B/S
Liabilities Presentation
Liabilities are presented in the order of when they are to be paid
Current Liabilities: Liabilities like short term debt and accounts payable to be paid
within 12 months; listed first
Long Term Liabilities: Liabilities like long term debt that are not due within the year;
listed last
Current vs. Non-Current B/S Exercise
Are interest payments on a loan a liability?
NO! Interest expense is recognized on the I/S with a corresponding reduction to cash.
Only the principal of the loan is recognized as a liability.
How would you characterize a long-term bank loan due this year?
A current liability
Long term debt migrates from a long term liability to a current liability on the B/S once it
becomes due within 12 months
Cash and equivalents
Cash equivalents are extremely liquid assets (ex. US treasury bills)
You'll also see marketable securities included in this line item or broken out separately
Prepaid Expenses
When a company prepays for things like utilities, insurance and rents, cash is reduced
but the expense is not yet recognized on the I/S under the accrual concept
Instead, they are recognized on the B/S as assets to reflect that the company now has
the right to the future services
Inventory
Represent goods waiting to be sold and direct and sometimes indirect costs associated
with the production or procurement of these goods
Merchandiser The products procured for resale
Manufacturer Includes the costs of producing the finished inventory: raw materials,
work-in-process (direct labor and factory overhead)
Inventory cycles out of the B/S and into I/S as COGS
Before inventory get expensed as COGS and are matched to the revenues they help
generate (matching principle), they are part of the company's inventories on the B/S
Inventory Exercise
Inventory Costing (LIFO vs. FIFO vs. Average Cost)
First In, First Out (FIFO): Cost of the inventory first purchased (first in) is the cost
assigned to the first inventory to be sold (COGS - first out); remaining inventory reflect
the latest costs
Last In, First Out (LIFO): The items purchased last (last in) are the first to be sold
(COGS - first out). Therefore, the cost of inventory most recently acquired (ending
inventory - last in) is assigned to COGS (first out); ending inventory reflects cost of the
first purchased inventories
Average Cost: COGS and ending inventory are calculated as = COGS / Total number
of goods
Inventory Costing Exercise
Why do companies choose LIFO?
The tax benefit of LIFO is what makes it preferable for many US companies over FIFO
accounting in periods of rising inventory prices
Why? LIFO leads to lower net income, which leads to lower taxes
LIFO Reserve
When companies use the LIFO method, their footnotes must disclose what the value of
their inventories would have been under the FIFO method; this difference is called
the LIFO Reserve
The LIFO reserve allows comparison of inventories and COGS across both methods:
LIFO Inventory + LIFO Reserve = FIFO Inventory
FIFO COGS + LIFO Reserve = LIFO COGS
In Practice: When comparing a LIFO company against a FIFO company, the LIFO
reserve must be subtracted from the LIFO company's COGS to arrive at apples-to-
apples profits comparisons
Writing Down Inventories
The B/S shows assets like inventories at historical (acquisition) cost -- companies can't
mark them up to market value under GAAP
Can they be marked down if inventory is destroyed, deteriorates or becomes
obsolete?
Yes! Under US GAAP, the lower of cost-or-market (LCM) rule dictates that if the
market value of inventory falls below historical cost, they must be written down to
market value
The loss must be recognized immediately on the Income Statement in COGS or 'Other
operating (or non operating) expenses' or a separate line item
On the Balance Sheet, there is a decrease in retained earnings (Equity) and inventory
(Asset)
Property, Plant & Equipment
Land, buildings, and machinery used in the manufacture of the company's services and
products plus all costs (transportation, installation, other) necessary to prepare those
fixed assets for their service
PP&E cycles out of the B/S and into the I/S as depreciation, either in COGS,
SG&A, or elsewhere
PP&E is reported net of accumulated depreciation on the balance sheet, such that: Net
PP&E = Gross PP&E - accumulated depreciation
Where Gross PP&E is the historical cost of all PP&E
Accumulated Depreciation
Netted away from gross PP&E to arrive at net PP&E on the balance sheet
Accumulated depreciation is a contra account, which is an offsetting account to an asset
(contra accounts also exist for liabilities and shareholders' equity)
Increases in a contra account reduce the associated asset account
Capital Expenditures
New purchases of PP&E (fixed assets)
PP&E Exercise
PP&E Write Downs
Just like inventory, PP&E whose value declines needs to be written down to market
value
The loss is recognized immediately on the I/S (COGS, SG&A, 'Other operating (or non
operating) expenses', or a separate line item)
On the B/S, the loss is taken out of PP&E
Asset Sales
If a company chooses to sell some of their PP&E, the associated gross PP&E balance
(and accumulated depreciation) is removed from the balance sheet, offset by:
(1) The cash received, and (when applicable)
(2) Any gain/loss on sale on the I/S (usually as "other" operating or non-operating
income, or within the expense category through which the asset was being depreciated
- COGS or SG&A)
Key Takeaway: Regardless of the sale price, only the net book value is removed from
the PP&E line, and any excell gain (loss) is recognized on the I/S
PP&E Balance During the Year
Intangible Assets
Comprised of non-physical acquired assets
Tems that have value based on the rights belonging to the company
Linked to amortization on the I/S
Intangible assets are reduced on the B/S via amortization on the I/S
Intangible Asset Balance During the Year
Goodwill
The amount by which the purchase price for a company exceeds its fair market value
(FMV), representing the "intangible" value stemming from the acquired company's
business name, customer relations, employee morale, etc.
Effectively an accounting plug, created only if the purchase price exceeds the FMV of all
the assets acquired
Goodwill Impairment
Unlike finite life intangible assets, Goodwill is not amortized but is tested annually for
loss of value (impairment)
If the value of the previously acquired company declines, goodwill is reduced, with a
corresponding reduction to RE via the income statement by the amount of the
impairment (as a separate line item or within a broader category)
Conceptually, goodwill write-downs imply that a company overpaid in the original
acquisition
Goodwill Balance During the Year
Liabilities
The company's obligations to others that will be met through the use of cash, goods, or
services
Qualifications:
(1) Measurable
(2) Probable occurrence
(3) The transactions from which these obligations arise have taken place
Categories:
(1) Current Liabilities: Due within 1 year - reported in order of maturity, by amount, or in
the event of liquidation
(2) Long-term Liabilities: Not due within a year
Deferred (Unearned) Revenue
Revenue received for services not yet provided by the company
A sizeable liability for software companies and companies that sell long-term
memberships
A current liability if the revenus is expected to be recognized within the year;
otherwise, a long-term liability
Types of Current Liabilities
Short Term Debt: Owed by the company that are due within 1 year
Current Portion of Long-Term Debt: Portion of long-term debt which is due within 1
year
Long Term Debt
A long-term liability that is often a sizeable liability
Note: Interest expense is a reduction to retained earnings and does not affect debt
balance
Leases
Many companies make lease payments for their equipment, office space, and retail
locations
Lease payments are defined contractually upfront between the lessee (the company
making lease payments) and the lessor (the company collecting lease payments)
Under IFRS, virtually all leases are accounted for as finance leases
Under US GAAP, leases can be accounted for as operating leases or finance
leases (see image)
Basically, if the lease is basically a transfer of ownership, it is a finance lease
Finance Leases
An accounting approach that recognizes the lease as debt and the underlying asset as
PP&E on the lessee's balance sheet
Lease as Debt: Like debt, leases are long-term obligations to make payments to
another party. Unlike debt, lease payments don't usually include explicit interest
payments; Instead, the interest fees are implied and baked into the total lease expense
Initial Balance Sheet Impact: Finance leases initially are recognized as a liability on
the B/S (just like debt) with the corresponding asset as PP&E
Note: Unlike debt, companies have to estimate the initial liability as the present value of
all future lease payments, using a discount rate assumption
Finance Leases: Over the Life of the Lease
Conceptually, the asset is depreciated (or amortized) over its useful life (or lease term, if
shorter), while the lease liability accrues interest during the year and is then reduced
by lease payments (like principal payments with debt)
On the I/S, both depreciation expense and an implied interest expense reduces net
income
Depreciation/Amortization Expense: The asset initially recognized is depreciated via
straight-line depreciation over the term of the lease
Interest Expense: The discount rate x The lease liability balance
Main Takeaway: The B/S initially treats the finance lease as a debt-like liability and the
underlying asset as an owned asset
Over the life of the lease, the I/S impact does not capture the rent but wants us to break
up the lease payments into two components: interest and depreciation fees
Note: Compared to the lease expense, the overall depreciation + interest expense will
be higher early in the lease and lower later in the lease because the interest
expense is higher when the lease liability is high
Operating Leases
Applies to leases where the lessee doesn't have economic ownership of the lease
Initial B/S Impact: Same as finance leases; initially are recognized as a liability on the
B/S (just like debt) with the corresponding asset as PP&E (Right of Use Assets)
I/S Impact Over Lease Term: I/S is reduced by the rent ("lease") expense
Straight-line Lease: If lease payments grow each year, the I/S will recognize an annual
straight line expense - creates a disconnect between the cash outlay and the accrual-
based expense recognized
Operating Leases - Lease Liability
Lease liability is treated identically under operating and finance lease accounting
(interest accruing and being reduced by lease payments)
The lease asset is reduced by depreciation expense but the calculation is different
Depreciation: The rent expense, net of the interest expense
Note: The lease liability and lease asset may not be exactly equal but will be very
similar
Equity
A major source of funds via:
(1) Preferred stock issuance
(2) Equity investment (net of share repurchases "treasury stock")
(3) Retained earnings (what the company has earned through operations since its
inception)
Common Stock
The primary way companies can raise money aside from debt
Accounting involves splitting the value of a common share into two components:
(1) Common Stock Par Value: Some nominal value to an issued share (ex.
$0.10/share)
(2) Additional Paid In Capital: The excess value of the share issued over par value
Note: Due to the historical cost principle, common stock on the B/S of most companies
grossly understates the true market value of their equity
Common Stock & Treasury Stock on Financial Statements
Treasury stock is sometimes an even larger amount on the B/S than common stock &
APIC due to the fact that common stock & APIC cannot be written up
Other Comprehensive Income (OCI)
An equity line item on the B/S that captures the accumulation of income or loss that a
company has recognized over time that is not recognized directly on the I/S and thus
not captured in retained earnings
Includes gains and losses from: Foreign currency transactions, unrealized gains and
losses on available for sale securities, etc.
Note: A full breakout of gains and losses categorized as OCI are often reported in a
separate financial statement called 'Statement of Comprehensive Income'
Common Stock & Stock Based Compensation
Equity issued to employees through stock based compensation (stock options and
restricted stock) increases the common stock & APIC balance
As the company recognizes stock based compensation on the I/S, it will recognize a
corresponding increase in the common stock & APIC balance
Note: There is no cash impact!
How to Calculate Retained Earnings
Net income - Dividends
Do collections of accounts receivable affect stockholders' equity?
No! They only affect cash and A/R
When a customer takes advantage of a sales discount, what does the discount
affect?
It increases operating expenses by the discount
Also: Cash increases by the price paid by the customer but A/R decreases by the full
price
Is ending inventory greater than beginning inventory when purchases are less
than COGS?
No! Ending inventory would be less than beginning inventory
When inventories are overstated, what is the effect on net income?
Current assets are overstated
COGS are understated
Net income is overstated
Is land held for investment part of PP&E?
No, it is reported on the B/S as an investment
The Cash Flow Statement (CFS)
A required financial statement that provides insight that the I/S cannot - namely, exactly
how much cash a company generates and from what activities
Reconciles net income to a company's actual change in cash balance over a period in
time (quarter or year)
Thus, the CFS and I/S must both be used and fully understood by analysts
Structure of the Cash Flow Statement
Companies have two options for reporting cash flows:
(1) Direct Method
(2) Indirect Method - Virtually all choose this one
Both approaches requires cash flows to be classified into three components:
(1) Cash from Operations (CFO): Uses net income as a starting point and converts
accrual-based net income into cash flow from operations via a series of adjustments
(i.e., non-cash and accrual)
(2) Cash from Investing Activities (CFI): Capital expenditures / asset sales and
purchases
(3) Cash from Financing Activities (CFF): New borrowing / pay-down of debt / new
issuance of stock / share repurchases; Issuance of dividends
Cash from Operations
How much cash went into the company's pocket as a result of operations?
Ignores non-cash income (credit sales, write-ups) and expenses (D&A, credit
purchases)
Start at net income and back all the non-cash expenses and income out of net income
to get at "cash income" or "cash from operations"
CFO: Depreciation
Often the biggest adjustment to get from net income to CFO is depreciation expense,
because it is usually the largest noncash expense included within net income
CFO: Working Capital
The other major adjustment from net income to CFO that is for a specific grouping of
B/S line items
Current assets like A/R, inventories, prepaid expenses are call "working capital"
assets
Current liabilities like A/P, accrued expenses, deferred revenue are called "working
capital" liabilities
Both represent assets and liabilities that are tied up in the ordinary course of operations
Note: Increases in assets represent a usage of funds (cash outflow); increases in
liabilities represent a source of funds (cash inflow)
CFO: Increases in assets & liabilities
Increases in assets represent a usage of funds (cash outflow)
Increases in liabilities represent a source of funds (cash inflow)
CFO: Other Items
Asset write downs / impairments: Since write downs or asset impairments are
recognized as an expense on the I/S, they represent a noncash expense that must be
added back on the CFS within CFO
Getting to Cash From Operations
Increases in A/R, inventory, prepaid expenses, other current assets should
be subtracted from net income to get to CFO
Increases in A/P, accrued expenses, other current liabilities should be added to net
income to get to CFO
Cash from Operations Exercise
Typical Line Items in the CFO
Cash from Investing Activities (CFI)
Tracks additions and reductions to fixed assets and investments during the year
(corresponding primarily to long-term asset side of the balance sheet)
Most Common Inflows/Outflows:
Capital expenditures (outflow)
Purchases of intangible assets (outflow)
Asset sales (inflow)
Purchases and sales of debt & equity securities (outflow/inflow)
Cash from Financing Activities (CFF)
Tracks changes in the company's sources of debt and equity financing (corresponding
primarily to the liabilities and shareholders' equity side of the B/S)
Most Common Inflows/Outflows:
Issuance / repayment of debt (inflow / outflow)
Common stock issued / repurchased (inflow / outflow)
Payment of common & preferred dividends (outflow)
The CFS is a Magnifying Glass
The CFS is a magnifying glass on the cash line of the B/S
CFS identifies the year-over-year change of every B/S line item that affects cash
CFO captures the impact of RE, current assets, and current liabilities (and the D&A part
of fixed assets and intangibles)
CFI capture the impact of long-term assets
CFF captures the impact of long-term liabilities and equity
Would a decrease in utilities payable be added or subtracted from net income
when determining cash flows from operating activities?
Subtracted! A decrease in utilities payable means that cash payments exceeded utilities
expense for the period
Would a gain on an asset sale be added or subtracted from net income when
determining cash flows from operating activities?
Subtracted!
Working Capital
A specific subset of balance sheet items
Working capital = Current assets – Current liabilities
Current Ratio
Current assets divided by current liability
Designed to provide a measure of a company's liquidity
> 1: A company is more liquid - has liquid assets that can presumably cover the
upcoming short-term liabilities
Quick Ratio (Acid Test)
Isolates only the most liquid assets (cash and receivables) to gauge liquidity
Working Capital Presentation on the BS with the CFS
The B/S organizes items based on liquidity, but the CFS organizes items based on their
nature (operating vs. investing vs. financing)
Most current assets and liabilities are related to operating activities - inventory, A/R,
A/P, accrued expenses, etc. are clustered under "changes in operating assets and
liabilities" in CFO
This section is generally referred to as "changes in working capital", but not all current
assets and liabilities are in this section
Ex. Marketable securities and short-term debt are not tied to operations - included in
investing and financing activities instead
Operating Items vs. Working Capital on the CFS
"Changes in operating assets and liabilities" commingles both current and long-term
operating assets and liabilities
Thus, it includes both working capital and other long-term assets and liabilities
What Does Working Capital Tell Us?
Not much -- a negative balance can be good, bad, or something in between
Operating Cycle
The time it takes, from start to finish, of buying or producing inventory, selling it, and
collecting cash for it
Includes cash, A/R, inventories, and A/P
Conceptually: The amount of days that it takes between when a company initially puts
up cash to get (or make) stuff and getting the cash back out after you sold the stuff
Net Operating Cycle (Cash Conversion Cycle)
A related concept to the operating cycle that factors in credit purchases
Operating cycle – payables payment period
Formulas Required to Calculate the Operating Cycle
Managing Working Capital
Companies with significant working capital considerations must carefully and actively
manage capital to avoid inefficiencies and possible liquidity problems
Perfect Storm:
(1) Retailer bought a lot of inventory on credit with short repayment terms
(2) Economy is slow, customers aren't paying as fast as was expected
(3) Demand for the retailer's product offerings change and some inventory flies off the
shelves while other inventory isn't selling
Working Capital Exercise
Financial Statement Ratio Analysis
Financial statement analysis relies on looking at relationships (ratios) between 2 or
more financial statement accounts and seeing how those ratios change over time, and
how they compare across companies or industries
Categories of Ratios:
(1) Liquidity ratios
(2) Profitability ratios
(3) Activity ratios
(4) Solvency ratios (coverage)
Activity Ratios
Measure how efficient a company is at using its assets
Inventory Turnover
If you need $50 in inventory jto support $1,000 in COGS that means you carry very little
inventory; can be advantageous because you do not need large amounts of cash for
inventory requirements until a sale is actually made
Had you needed large inventory purchases prior to the sale, you would have had to tap
other financing sources like debt
Receivable Turnover & DSO
Identical conceptually to inventory turnover
If you collect very fast from customers, you immediately get cash
If you wait a long time for customers to pay, cash that you need for other activities
would have to come from somewhere else (like debt)
Receivable turnover = Revenue / Average accounts receivable
Another way to express the relationship between A/R and sales is days sales
outstanding (DSO) = (AR/Credit sales) x days in period
Note: You want DSO to be low
AP Turnover and Payables Payment Period
Measures how quickly a company pays its vendors
Generally, the longer credit terms provide a company with more flexibility

If the average DSO is greater than the average PPP, cash from customers takes longer
to collect than the term your vendors have provided you - implies that you cannot rely
on receivables alone to fund your short term credit terms so you'll need to access other
capital sources
Activity Ratios Exercise
Exercise 3 = 46 days
Note: DSO should be low; Inventory turnover should be high; PPP should be high
Liquidity Ratios
Gauge the ability of a company to cover short term financing needs
Rough Rule of Thumb: A current ratio > 1 is good; it implies that there are more liquid
assets than short term liabilities, reflecting a healthier level of liquidity
The Flip Side: Companies with very strong working capital management can operate
effectively with lower liquidity ratios, enabling them to fund activities more efficiently
Profitability Ratios
Operating Margin
Like GPM but captures operating (non-direct) expenses like SG&A
Operating profit / Revenue
Higher margin = better
Net Profit Margin
Like GPM but captures all non-operating income/expenses
Net income / Revenue
Higher margin = better
Asset Turnover
Revenue / Average assets
A business with $500 in assets and $1,000 in revenue has a 2x asset turnover - could
be far more capital intensive than a business that achieves the same sales with only
$100 in assets
Alternatively, it could just have a lot more cash
Return on Assets (ROA)
Net income / Average assets
Measures how effective a company is at converting assets into profits, as opposed to
just revenue
Higher return = Better
Although, there are many possible scenarios that make this rule of thumb less than
perfect
Return on Equity (ROE)
Net income / Total equity
One of the challenges with ROA is that it commingles a levered measure of profitability
(net income is sensitive to leverage via interest expense) with an unlevered measure of
assets (assets can be financed by a lot of leverage or no leverage at all)
Thus, ROA makes a poor ratio to use when comparing companies with significantly
different rates of leverage
ROE solves this by factoring leverage into the denominator and calculates a return on
just the equity value of the firm; this facilitates the analysis across companies with
varying degrees of leverage
Leverage and Solvency Ratios
Important to investors (especially lenders) as they try to determine whether borrowers
have sufficient profits to make interest payments and sufficient equity to carry debt
Debt to EBITDA
Debt / EBITDA
Used to determine a company's debt capacity
Ex. Lenders contemplating lending to a company with EBITDA of $100m restrict the
loan amount to 5.0x the company's EBITDA
Interest and Fixed Charge Coverage Ratios
Interest coverage ratio = EBIT / Interest expense
Fixed charge coverage ratio = (EBIT + Lease charges) / (Lease charges + Interest
expense)
Analyze how much profit is available to satisfy interest expense
Coverage ratios are often included in credit agreements whereby a borrower must
maintain a certain ratio to be in good standing with the lender
Note: Sometimes lenders adjust EBIT to better approximate cash profits because it
captures many noncash items
Debt to Equity Ratio
Total liabilities / Total equity
Used to understand how levered a company is
The higher to D/E, the more highly levered a firm is
A measure of investor and credit risk
Note: Since the book value of equity can seriously understate the market value of
equity, a market value of equity should be used to better understand leverage