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Overview of Financial Accounting

Session 1
Accounting 502

The Goal of Accounting

Accounting provides information to
decision-makers

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Where Did Accounting Come

From?
People seem to think some old Italian created
accounting for the newly strong merchant class

Where Did Accounting Come

From?
But really accounting is an old as
civilization, independently created
across ancient cultures

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Why Invent Accounting?

• Accounting arose from a need for information
– Organized activities and societies need ways of
tracking their activities
• Accountants sometimes forget this simple
beginning
– Jargon and other barriers begin to abound
• The commonsense beginning means we can
always tie back to commonsense motivation

The Two Big Questions in Life

What is the financial How well did the

condition of an organization organization perform
on a given day? during a given
period?

Income Cash Flow

Statement Statement

Balance Sheet Statement of

Stockholders’ Equity

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Environment of
Accounting
Managerial
reports Managerial
ACC552 decisions

Operations of the Financial Capital market

business entity statements resources

Contractual
GAAP/IFRS Audit payoffs

Tax return Direct cash flow

The Balance Sheet or

Statement of Financial Position

“Snapshot of Firm”
Assets = Liabilities + Shareholders’ Equity

• What Do I Have?

• Where Did I Get It?

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The Balance Sheet

Assets = Liabilities + Shareholders’ Equity

Future Owed to Value Created but

Value Outsiders Not Distributed
Creation
Contributed by Owners

(Residual)
(What I Own) = (What I Owe) + (Book Value)
(Net Worth)

A502 Financial Accounting: Overview 9

Definitions - Assets
• Asset Concept Statement 6 (old, training wheels)
– Probable future economic benefits obtained or controlled
by the firm as a result of past transactions or events.

• Asset Concept Statement 8 (new, “concise”)

– A present right of an entity to an economic benefit

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Definitions - Liability
• Liability Concept Statement 6 (old, training wheels)
– Probable future economic sacrifices arising from present
obligations as a result of past transactions or events.
• Liability Concept Statement 8 (new, “concise”)
– A present obligation of an entity to transfer an
economic benefit

A502 Financial Accounting: Overview 11

Definitions – Shareholders Equity

• Shareholders’ Equity
– Residual (includes earned capital and capital contributed
by shareholders)

Assets = Liabilities + Shareholders’ Equity

Assets - Liabilities = Shareholders’ Equity

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The Income Statement or

Profit and Loss (P&L) Statement
Revenue – Expenses = Net Income (or Net Loss)

•What came into the firm?

•What did we use up to get it?
•How much net value did we create this period?

Definitions:
Revenues – Inflows or other enhancements of assets of an entity or settlements of
its liabilities (or a combination of both) from delivering or producing goods, rendering
services, or carrying out other activities
Expenses – Outflows or other using up of assets of an entity or incurrences of its
liabilities (or a combination of both) from delivering or producing goods, rendering
services, or carrying out other activities

A502 Financial Accounting: Overview 13

Developing the Statements

• Basic building block of the statements is the
individual transaction
– Sale, purchase, payment, …
• The accounting process shows how to go from
transactions to statements
– Analyze
– Journalize
– Post to T-Accounts

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Example
• We start a new business and make the
following transactions
(1) Contribute $400 in cash as initial capital
(2) Borrow $200 in capital from bank
(3) Purchase a computer for $300 cash
(4) Purchase merchandise for $50 on account
• How does each of these transactions affect
the balance sheet?

A502 Financial Accounting: Overview 15

Analyze Transactions
Transaction Assets = Liabilities + Equity

(1) $400 = + $400

(2) $200 = $200

(3) -$300 + $300 =

(4) $50 = $50

(Balance) $650 = $250 + $400

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Journalizing and Posting

• Bookkeeping is the process of recording the
transactions in the company books
• Based on the debit-credit system

Assets = Liabilities + Shareholders’ Equity

Debit Credit Debit Credit Debit Credit

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Journalizing and Posting

• Transactions are recorded in a journal and
posted in T-Accounts
• Journal entry example
– Borrow $500 from the bank

Dr. Cash (an asset) $500

Cr. Loan (a liability) $500

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T-Accounts
• T-Accounts provide a visual representation of
how a transaction is recorded in the ledger

Account Title
Debits Credits

(Dr) (Cr)
Always on Always on
the left the right

A502 Financial Accounting: Overview 19

Posting Our Four Transactions

Cash Shareholders’ Equity Loan
(1) 400 400 (1) 200 (2)

(2) 200 300 (3) 400 (EB) 200 (EB)

(EB) 300

Equipment Inventory Accounts Payable

(3) 300 (4) 50 50 (4)

(EB) 300 (EB) 50 50 (EB)

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Example (Cont’d)
• Referring back to example, consider an additional transaction
(5) Sells all its merchandise for $100 in cash
• How does this affect the balance sheet and income statement?

Transaction Assets = Liabilities + Equity Revenues Expenses

(Previous Balance) $650 = $250 + $400

(5a) $100 $100 $100
(5b) -$ 50 -$ 50 $50
5a) Dr. Cash (an asset) $100
Cr. Sales Revenue (a revenue) $100
5b) Dr. Cost of Goods Sold (an expense) $ 50
Cr. Inventory (an asset) $ 50

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About the Course

• Official Goal: skills to understand and use accounting as
a MANAGER or INVESTOR
– Will not try to turn you into a CPA
• Cover basic accounting process and underlying theories
• Provide a base upon which future skills can be built
• Unofficial Goal: “I wish I were an accountant”

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Course Details
• Syllabus
• Textbook –
– On line version, bargain price
• Evaluation
– Participate, Post Answers, Perform on Quizzes
• Why cases?
– And what does it take to be good at them?

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 Revenue Recognition and
Accounts Receivable
Accounting 502
Session 3

Agenda
• Economics of revenue recognition
• Accounting for revenue
• Measurement issues
• Management bias
• Bookkeeping mechanics
• Accounts receivable

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 Economic Reality

• When can a firm claim to have generated

value through transacting with their
customers?

A502: Revenue Recognition 3

Economic Reality
• When does a firm make a “sale?”

Produce Deliver
Firm: Time

Customer: Order and Return? Discard

payment

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 Economic Reality
• When does a firm make a “sale?”

Produce Deliver
Firm: Time

Customer: Order Payment Return? Discard

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Economic Reality
• When does a firm make a “sale?”
– Examples
• Barber
– Delivery and payment simultaneous
• Consulting
– Contract signed for long-term relationship
• Airline
– Purchase might be 11 months before delivery
• What is the “product” or “service?”
– American Airlines
– Travelocity

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 Accounting for Revenue (Big Picture)
• Accounting requires the following
– Revenue must be earned (are you done?)
• Risk of ownership has passed
• Seller has executed substantially all the requirements of
the sales agreement
– Revenue must be realized or realizable (have you
been paid or will you be paid?)
• Seller has received cash or a cash equivalent (generally
will turn into cash, but other items of value may
qualify)

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Newish Revenue Recognition

• FASB has issued revised guidance on

accounting for revenue
– ASU-2014-09
• Effective for annual reporting periods
beginning after December 15, 2018
– For interim reporting periods beginning after
December 15, 2019

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 Revised Revenue Recognition
• Core Principle: “Recognize revenue to depict
the transfer of … goods or services ... in an
amount that reflects the consideration … the
entity expects ... in exchange for those goods
or services”
• Achieving this requires the firm to apply five
“steps”

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Five Steps for Revenue Recognition

• Step 1. Identify the contracts with the customer
• Step 2. Identify the performance obligations in
the contract
• Step 3. Determine the transaction price
• Step 4. Allocate the transaction price to the
performance obligations
• Step 5. Recognize revenue when the entity
satisfies an obligation
– Source: ASU-2014-09, pg. 2

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 Step 1 is “Realized”
• “Step 1. Identify the contracts with the customer”
has five steps (hmm, a theme)
1. Approval and commitment of the parties
2. Identification of the rights of the parties
3. Identification of the payment terms
4. The contract has commercial substance
5. It is probable that the entity will collect the
consideration to which it will be entitled in exchange for
the goods or services that will be transferred to the
customer.
– Source: ASU-2014-09, pg. 2

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Steps Two through Five are “earned”

• Step 1. Identify the contracts with the customer
• Step 2. Identify the performance obligations in
the contract
• Step 3. Determine the transaction price
• Step 4. Allocate the transaction price to the
performance obligations
• Step 5. Recognize revenue when the entity
satisfies an obligation
– Source: ASU-2014-09, pg. 2

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 Examples
• How would you apply this to
– Selling a shirt for cash?
– Selling a one-year subscription of a monthly news
magazine?

• How does this differ from current guidance?

– Same result
– Explicit thought process

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Accounting for Revenue

• Revenue can be recognized before, at, or after
delivery of the product or service

Delivery

Common
Recognize: Recognize:
Long-term contracts where Substantial right of return
payment relatively assured exists and is difficult to
estimate or collection of cash
is uncertain
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 Measurement Issues
• Right of return
– Recognize revenue if it can be reasonably
estimated, otherwise wait until return period ends
• Long-term contracts
– Recognize as services delivered
(e.g., subscriptions)
– Recognize as paid if payment unsure

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Management Bias
• Valuation models often focus on revenue
– Higher revenues imply higher firm values
• Revenue is the largest item on the income
statement and flows down through other
accounts
• Revenue recognition issues are a part of most
restatements and SEC enforcement actions

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 Recording Revenue
• Three examples
– Sell merchandise for $200 cash
– Sell merchandise for $400 on account
– Sell merchandise to a creditor for forgiveness of
a $600 payable

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Journalizing Sales
(1) Cash 200
Revenue 200

(2) Accounts receivable 400

Revenue 400

(3) Accounts payable 600

Revenue 600

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 Posting Sales
Cash Accounts Receivable Revenue
(1) 200 (2) 400 200 (1)

400 (2)

600 (3)

Accounts Payable
(3) 600

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Recording Sales
Balance Sheet Income Statement
Assets = Liabilities + Equity Revenue – Expenses = Net
Income
(1) Cash = + Retained
Earnings
$200 = $200 $200 – = $200

(2) Accounts = Retained

Receivable Earnings

$400 = $400 $400 – = $400

(3) Accounts + Retained

Payable Earnings
– $600 $600 $600 – = $600

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 Accounting for Receivables
• Economic question
– What amount will I really receive?
• Applying the definition of an asset, what will be the
economic benefit?
• Alternatively, will some accounts be uncollectible?

• Three accounting issues

– Estimating uncollectible accounts
– Recording estimate of uncollectible accounts
– Recording write-offs when seller determines a
specific account will not be collected
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Accounting for Receivables Example

• At the end of 2018, a newly formed company
(started Jan 3rd, 2018) had a $900,000 balance in
receivables. How do we calculate bad debt expense?

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 Estimating Uncollectible Accounts
Aging accounts (December 31, 2018):

Accounts Estimated Percent Accounts Estimated

Age of Accounts Receivable Balance Uncollectible Uncollectible
Current $ 560,000 .625% $3,500
1-30 days past due 300,000 3.0 9,000
31-90 days past due 30,000 3.3 1,000
Over 90 days past due 10,000 15.0 1,500

Total $900,000 $15,000

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Accounting for Receivables

• Example
Balance Sheet Income Statement
Accounts Receivable Allowance for
(Gross) Uncollectible Accounts Bad Debt Expense
End 900,000 15,000
2018 (1) 15,000

(1) Calculated on prior slide

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 Accounting for Receivables Example
• In 2019, the company had credit sales of
$10,000,000.
• In 2019, the company collected $9,900,000 “on
account” from their customers and thus have
accounts receivables of $1,000,000.
• How do we calculate bad debt expense?

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Accounting for Receivables

• Example
Balance Sheet Income Statement
Accounts Receivable Allowance for
(Gross) Uncollectible Accounts Bad Debt Expense
End 900,000 15,000
2018

10,000,00
9,900,000 ???

End
2019 1,000,000 ???

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 Estimating Uncollectible Accounts
Aging accounts (December 31, 2019):

Accounts Estimated Percent Accounts Estimated

Age of Accounts Receivable Balance Uncollectible Uncollectible
Current $ 700,000 1% $7,000
1-30 days past due 200,000 3 6,000
31-90 days past due 80,000 5 4,000
Over 90 days past due 20,000 20 4,000

Total $1,000,000 $21,000

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Accounting for Receivables

• Example
Balance Sheet Income Statement
Accounts Receivable Allowance for
(Gross) Uncollectible Accounts Bad Debt Expense
End 900,000 15,000
2018

10,000,000
9,900,000 6,000 (1) (1) 6,000

End
2019 1,000,000 21,000

(1) $6,000 = $21,000 – $15,000

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 Accounting for Receivables
(2) On January 5, we determine Jones, Inc. will not pay its
receivable of $2,000.
Balance Sheet Income Statement
Accounts Receivable Allowance for
(Gross) Uncollectible Accounts Bad Debt Expense

End
2018 900,000 15,000

10,000,000 9,900,000 6,000 (1) (1) 6,000

End
2019 1,000,000 21,000

1/5/2020 2,000 (2) (2) 2,000

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 Inventory and Cost of Goods Sold

Accounting 502
Session 4

Agenda
• Economics of inventory
• Accounting for inventory
• Measurement issues
– What belongs in inventory
– What is the value of the inventory
• Management bias
• Bookkeeping
– Recording inventory and cost of goods sold

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 Economic Reality
• What does it cost you to sell merchandise to
customers in normal operations? When should you
reflect these costs on your income statement?

Place in Pay Sell to Collect from

Order Inventory Supplier Customer Customer
Firm:

Supplier: Deliver Time

Recognizing Expenses
• Matching principle
– Expenses should be recognized in the same period as the
associated revenues
• Direct association is used when the link between the
cost and the revenue is reasonably clear
– Recognize the cost as an expense in the same period as the
revenue generated by those costs
• A unit of revenue has a unit of expense
• Inventory in cost of good sold exemplifies a direct situation

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 What Constitutes “Inventory”
• Inventory includes the cost to acquire (or produce)
goods for sale
– For manufacturing firms that includes all the costs of
completing the goods, which means components
purchased to be used in production, labor, the use of
machines etc.
– For a retailer, this includes the cost of transportation

Included in Inventory Costs?

• Freight expenses • Operating costs at
associated with moving stores and
merchandise to headquarters
distribution centers and • Advertising
stores • Pre-opening costs
• Inventory shrink • Administrative costs
• Distribution center costs

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 Answer
• Target, per 2015 Annual Report (page 40)
– Left-hand side are costs of goods sold
– Right-hand side are SG&A costs
• Walmart, per 2016 Annual Report (page 43)
– First two and a small portion of third (distribution
center costs) are costs of goods sold
– Right-hand side and most distribution center costs
are SG&A costs

How Can We Get Different Answers?

• Target also states:
– “The classification of these expenses varies across the
retail industry.”

• Walmart also states

– “Because the Company does not include most of the cost
of its Walmart U.S. and Walmart International segments’
distribution facilities in cost of sales, its gross profit and
gross profit as a percentage of net sales may not be
comparable to those of other retailers that may include all
costs related to their distribution facilities in cost of sales
and in the calculation of gross profit.”

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 Overview of Cost Flows
• Inventory is capitalized and carried on the balance
sheet until sold
• When sold, the cost of inventory is transferred to
cost of goods sold on the income statement
• In this way, cost of goods sold is matched with the
associated revenue the goods generated
• The difference between revenue and cost of goods
sold is gross profit:
Gross profit = Revenues – Cost of goods sold

Inventory Flows – Units

Units How to Determine
(Shirts)
(1) Beginning inventory 100 Count
(= Ending inventory last period)

(2) + Purchase 900 Purchase orders

(3) = Available for sale 1,000 Compute [= (1) + (2)]

(4) – Ending inventory 200 Count

(5) = Used (sold, lost, stolen …) 800 Compute [= (3) – (4)]

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 Inventory Flows – Cost
• Example: Cost of shirt is $10

Units
(Shirts) Cost
Beginning inventory 100 $ 1,000
+ Purchases 900 9,000
= Available for sale 1,000 $10,000
– Ending inventory 200 2,000  Balance sheet
= Sold (or lost, stolen, …) 800 $ 8,000  Income statement

Inventory Flows – Costs

• Now, suppose the new shirts purchased cost $20
– Shirts in beginning inventory were purchased for $10
– What would be the ending balance? the COGS?
• What shirts did we sell? What shirts are still in
inventory?
• Two obvious alternatives:
(1) Sell from the “bottom” of the shirt pile
(2) Sell from the “top” of the shirt pile

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 Inventory Flows – Costs
Sell from Bottom of Pile Sell from Top of Pile
Beg. Inv. $1,000 (= 100 x $10) $1,000 (= 100 x $10)
Purchased 18,000 (= 900 x $20) 18,000 (= 900 x $20)
Available $19,000 $19,000
End. Inv. 4,000 (= 200 x $20) 3,000 (= 100 x $20 + 100 x $10)
COGS $15,000 ( = 100 x $10 + $16,000 (= 800 x $20)
700 x $20)

Costing (Valuing) Inventory

Three common methods:
First-in, first-out Assumes the oldest costs are the first
(FIFO) costs transferred to cost of goods sold
Last-in, first out Assumes the most recent costs are the
(LIFO) first costs transferred to cost of goods
sold
Average cost Assumes the cost of goods sold is the
average cost of all inventory available
for sale
Specific Track each item individually
Identification

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 Recording Inventory Transactions
Transaction 1: Target purchases 1,000 shirts for $20 each (cash)
Balance Sheet Income Statement
Net
Assets = Liabilities + Equity Revenue Expense = Inc.
(1) Cash Inventory = +

($20,000) $20,000 =

(1) Inventory 20,000

Cash 20,000

Cash Inventory
20,000 (1) (1) 20,000

Recording Inventory Transactions

Transaction 2: Target sells 800 shirts for $30 each (cash)

Balance Sheet Income Statement

Net
Assets = Liabilities + Equity Revenue Expense = Inc.
(2) Cash Inventory = + Retained
Earnings
24,000 (16,000) = 8,000 24,000 – 16,000 = 8,000

(2) Cash 24,000

Revenue 24,000

Cost of goods sold 16,000

Inventory 16,000

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 Recording Inventory Transactions
Transaction 2: Target sells 800 shirts for $30 each (cash)

Cash Inventory
20,000 (1) (1) 20,000
(2) 24,000 16,000 (2)

Revenue Cost of Goods Sold

24,000 (2) (2) 16,000

Inventory Costing is an Assumption

• In most firms the physical flow is neither FIFO
nor LIFO (and probably never average)
• The costs of tracking every component of
every item is prohibitive, so an assumption is
allowed
• Once made, it cannot be changed without a
very good reason that is approved by
regulators

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 Costs of Goods Sold, but not
Inventory?
• While inventory costs eventually become a
part of costs of goods sold, not all items in
costs of good sold come from “capitalized”
inventory costs
• Examples that may be in COGS:
– Estimated product warranty costs
– Excessive scrap or excess capacity

Lower of Cost or Net Realizable Value

• Inventory is reported at the lower of cost or NRV
– If NRV of inventory is greater than acquisition cost, it is
reported at acquisition cost
– If net realizable value of inventory is less than acquisition
cost, it is reported at net realizable value. NRV generally is
the amount it will be sold for (market value) less any costs
to complete it and make the sale
– Once written down, under US rules it cannot be “written
up” even if net realizable value goes up to a level greater
than original acquisition cost

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 IFRS and Taxes
• Inventory costing is similar between GAAP and IFRS
with one major exception and several minor
• IFRS (currently) does not allow LIFO under the
argument is it costly and adds no benefit over FIFO
• In the US, LIFO has tax benefits
– Since prices usually rise, the lower reported income means lower taxes
– IRS requires firms using LIFO for tax reporting use it for financial
reporting as well (called the LIFO Conformity rule)
• Because of the tax benefits, this will likely be a
contentious issue

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Depreciation and Property, Plant

and Equipment
Accounting 502
Session 5

Agenda
• Economics of Property, Plant and Equipment
• Accounting for PP&E
• Measurement issues
• Management bias
• Bookkeeping mechanics

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Economic Reality
• As firms create value, they often use assets
that have long lives.
– Some portion of this value is used up every
period, while other amounts remain for the
future.
• In other words,
– What asset do we have now?
– How much asset value (“depreciation” or
“amortization”) was used during this period?

Economic Reality
• A simple asset
Portion Asset
Asset of Asset Disposed
Purchased Remains

Asset Used Asset Used

EOY EOY

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Economic Reality
• A more complicated (realistic) asset
Portion
Asset Further of Asset
Purchased Investment Remains Asset Sold

Asset Used Asset Used

EOY EOY

Economic Reality
• Assets and their use
– Examples
• You buy a car for personal use
– Drive to work, play, and everything else
• A high end livery company buys a car
– Always need clean and new-looking cars for high end clients
(MBA students), after a few years sell or use for lower end
clients (faculty mostly)

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Accounting for Long Lived Assets

• Determine whether the cost is an asset

• If so, accounting requires the following:

– How much you paid (acquisition cost)

– How long/much you will use it (useful life)

– Expected worth at end (salvage value)

– Allocation of use (method)

Example Depreciation Calculations

1) (Acquisition Cost – Salvage Value)

Useful Life (years)

2) (Acquisition Cost – Salvage Value)

Useful Life (units)

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Measurement Issues
• Must predict use and value far into the future
– Technology changes, future demand, etc. are all
embedded
• Based on specific firm’s use, not economic life or
market value
– Can change as business model or competitive position
changes
– May not be able to compare to other firms
• Usually can’t observe true usage even after it
occurs

Management Bias
• Long term nature means biases may take a long
time to show up
– Creates temptation
• Managers likely to reassess usage (and thus
change policies) when under pressure to perform
– When times get tough, you stretch what you have
operationally, but also means change reporting
• Incentive to “cherry pick” retirements/sales
based on current performance

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Applying the Accounting

• Pay $95,000 for an airplane, plus $5,000 to
customize it to firm’s needs

• Plan to use for 10 years, but will last 15

• Expect to be able to sell it for $40,000

• Use straight-line depreciation

Depreciation Accounting
(95,000 + 5,000 ) – 40,000 = 60,000 = $6,000 per year
10 10

Purchase
(1) Property, Plant & Equipment 100,000
Cash 100,000
Year 1
(2) Depreciation Expense 6,000
Accumulated Depreciation 6,000
Year 2
(3) Depreciation Expense 6,000
Accumulated Depreciation 6,000

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Depreciation Accounting

Balance Sheet Income Statement

PP&E Accumulated
(Gross) Depreciation Depreciation Expense
Year 1 (1) 100,000 6,000 (2) (2) 6,000

(EB) 100,000 6,000 (EB)

Year 2 Depreciation Expense

0 6,000 (3) (3) 6,000

(EB) 100,000 12,000 (EB)

Change in Accounting Estimate

• Now, let’s assume in year 3 that conditions have
changed such that the company expects to use
the airplane for 14 years (rather than 10 years)

• Given the extra usage, the salvage value is

estimated to be 22,000 (rather than 40,000)

*How do we account for this change in estimate?

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Change in Accounting Estimate – Year 3

88,000 – 22,000 = 66,000 = $5,500 per year
12 12

Balance Sheet Income Statement

PP&E
(Gross) Accumulated Depreciation Depreciation Expense
Year 3 (BB)100,000 12,000 (BB)

0 5,500 (4) (4) 5,500

(EB) 100,000 17,500 (EB)

Depreciation Expense
Year 4 0 5,500 (5) (5) 5,500

(EB)100,000 23,000
(EB)

Year Depreciation Accumulated (Gross) Net

Expense Depreciation Book Value Book Value
1 $6,000 $6,000 $100,000 $94,000
2 6,000 12,000 100,000 88,000
3 5,500 17,500 100,000 82,500
4 5,500 23,000 100,000 77,000
5 5,500 28,500 100,000 71,500
6 5,500 34,000 100,000 66,000
7 5,500 39,500 100,000 60,500
8 5,500 45,000 100,000 55,000
9 5,500 50,500 100,000 49,500
10 5,500 56,000 100,000 44,000
11 5,500 61,500 100,000 38,500
12 5,500 67,000 100,000 33,000
13 5,500 72,500 100,000 27,500
14 5,500 78,000 100,000 22,000
Total $78,000

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Sell Asset for Book Value

Cash 22,000

Accumulated Depreciation 78,000

PP&E 100,000

Sell Asset at Price Other Than Book Value

Cash 30,000 108,000

Accumulated Depreciation 78,000

PP&E 100,000

Cash 20,000 98,000

Accumulated Depreciation 78,000

PP&E 100,000

9
 9/6/2023

Sell Asset at Price Other Than Book Value

Cash 30,000
Accumulated Depreciation 78,000
Gain 8,000
PP&E 100,000

Cash 20,000
Accumulated Depreciation 78,000
Loss 2,000
PP&E 100,000

When Does Depreciation Become an Expense?

Earlier we considered a “service” firm where the asset was used in the
period it generated revenue. We recorded the following journal
entry to recognize the cost (expense) of using the asset that period:
Depreciation Expense 6,000
Accumulated Depreciation 6,000

“Manufacturing” firms often use their long-term assets to create

another asset ( usually inventory) . The cost of those assets is not
expensed until the inventory is sold (which is when revenue is
generated):
Inventory 6,000

Accumulated Depreciation 6,000

COGS 6,000
Inventory 6,000

10
 9/6/2023

PP&E Cost Flow for Manufacturing: An

Example
1. On January 1, 2015, Tees-R-Us (TRS) manufacturing company
opens for business. They purchase a machine for $100,000 that
cuts the patterns and stitches t-shirts. TRS plans to use the
machine for 10 years and expects to sell it for $40,000. They use
straight-line depreciation.

2. During 2015, TRS also purchases thread and cotton (raw materials)
to make the t-shirts for $1,500.

3. TRS hires employees to produce the t-shirts and incurs $10,500 in

wage expenses.

4. In January of 2016, TRS makes their first sale of t-shirts (they sell
to A&E shirts). A&E buys all of the inventory that TRS has
produced.

PP&E Costs Flow: Manufacturing

Balance Sheet Income Statement

PP&E Accumulated
(Gross) Depreciation Inventory
Jan, 2015 (1) 100,000 6,000 (1) (1) 6,000
(2) 1,500
(3) 10,500

(EB)100,000 6,000 (EB) (EB) 18,000

COGS
Jan, 2016 18,000 (4) (4) 18,000

11
 9/6/2023

Summary: Accounting for Long-Lived

Assets
• Use all cost of acquisition, projected use and
salvage value to estimate value used each period
• Periodic reassessments of these estimates
– Change in estimates reflected going forward
• “Settled” at the end of asset usage via a gain or
loss
– A gain indicates the asset was “over-depreciated” in
the past
– A loss indicates the asset was “under-depreciated” in
the past

12
 Amortization and Intangible
Assets
Accounting 502
Session 6

Agenda
• Economics of intangible assets
• Accounting for intangible assets
• Measurement issues
• Management bias
• Bookkeeping mechanics
• Goodwill – a special case

A502: Intangible Assets 2

1
 Economic Reality
• As firms create value, they often use assets that have
long lives – some of those assets are not physical in
nature.
– Some portion of this value is used up every period, while
other amounts remain for the future.
• In other words,
– What asset do we have now?
– How much asset value (“amortization”) was used during
this period?

A502: Intangible Assets 3

Economic Reality
• A (realistic) intangible asset
Portion
Asset Further of Asset
Purchased Investment Remains Asset Sold

Asset Used Asset Used

EOY EOY

A502: Intangible Assets 4

2
 Economic Reality
• Assets and their use
– Examples
• A company creates a blockbuster drug with massive
sales potential
– Develops drug via R&D, proof of effectiveness, and safety via
clinical trials, legally files trademarks and patents
• A company buys the rights to a blockbuster drug
created by another company
– Gets developed drug supported by medical research and
government approval, existing trademarks and patents

A502: Intangible Assets 5

Accounting for Intangible Assets

• HUGE problem is determining when an “asset” is
created
– That is, when do we reach the point of “probable future
economic benefit”?
• In U.S., this has led to limiting capitalization primarily
to intangibles that are purchased externally
• IFRS allows more latitude, but still a preference
towards externally purchased assets

A502: Intangible Assets 6

3
 Accounting for Intangible Assets
• Accounting requires the following:
– How much you paid (acquisition and completion cost)
• Easy if buy externally; close to impossible if developed internally
– How long/much you will use it (useful life)
• Limited legal life provides guidance
• Much harder for other assets as they are not physically used up
– Expected worth at end (salvage value)
• Easy if limited legal life; guesstimate otherwise
– Allocation of use (method)

A502: Intangible Assets 7

Example Amortization Calculations

1) (Acquisition Cost – Salvage Value)

Useful Life (years)

2) (Acquisition Cost – Salvage Value)

Useful Life (units)

A502: Intangible Assets 8

4
 Measurement Issues
• Every problem you have with long lived physical
assets, but more extreme

• What do you really have? Often very unique, so how

do you value it?

• When value disappears, it often happens quickly

A502: Intangible Assets 9

Management Bias
• All of the problems from long-lived physical assets

• Management often has significant private

information, but outsiders may not even know the
information exists

• Much harder for auditors or other outsiders to

objectively evaluate

A502: Intangible Assets 10

5
 Applying the Accounting
• Pay $95,000 for a patent, plus $5,000 to legally
secure the transfer of ownership

• Plan to use for 10 years, but legal life is 15

• Expect to be able to sell it for $40,000

• Use straight-line amortization

A502: Intangible Assets 11

Amortization Accounting
(95,000 + 5,000 ) – 40,000 = 60,000 = $6,000 per year
10 10
Balance Sheet Income Statement
Intangible Assets (or Patent)
(Net) Amortization Expense
Year 1 (1) 100,000 6,000 (2) (2) 6,000

(EB) 94,000
Year 2 Amortization Expense

0 6,000 (3) (3) 6,000

(EB) 88,000

A502: Intangible Assets 12

6
 Journalizing Intangibles
Purchase (1) Patent 100,000
Cash 100,000

Year 1 (2) Amortization Expense 6,000

Patent 6,000

Year 2 (3) Amortization Expense 6,000

Patent 6,000

A502: Intangible Assets 13

Goodwill – Process
• When company A purchases company B, it must:
1) Revalue all “identifiable” assets to their fair value at
the time of the purchase
2) Revalue all “identifiable” liabilities to their fair value
at the time of purchase
3) Calculate goodwill

A502: Intangible Assets 14

7
 Goodwill – Example
• Company A gives $100,000 cash to the owner of
company B
• Company A gets assets with a fair value of $80,000
(Company B’s book value of assets was $25,000)
• Company A agrees to assume Company B’s liabilities
that have a fair value of $15,000 (Company B’s book
value of liabilities was $13,000)

A502: Intangible Assets 15

Goodwill – Calculation Per Standards

Cash Consideration Given $100,000

Less: Fair Value of Identifiable Assets $80,000
Plus: Fair Value of Identifiable Liabilities 15,000
Fair Value of Net Identifiable Assets 65,000
Goodwill $35,000

A502: Intangible Assets 16

8
 Goodwill – Calculation More Intuitive

Cash Consideration Given $100,000

Other Consideration Given (Liabilities $15,000
Assumed)
Total Given Up $115,000
Less: Fair Value of Identifiable Assets $80,000
(Things I can identify I got)

Goodwill (excess I paid beyond what I can $35,000

identify)

A502: Intangible Assets 17

Journalizing Goodwill

Record all items you can “observe” per accounting requirements:

Identifiable Assets 80,000

Cash 100,000
Identifiable Liabilities 15,000

Total Debits (What I Got)= 80,000

Total Credits (What I Gave Up)= 115,000

A502: Intangible Assets 18

9
 Journalizing Goodwill

Compute and record the difference between what “Got” and

what “Gave Up”:
Non-identifiable Assets (plug) 35,000
Identifiable Assets 80,000
Cash 100,000
Identifiable Liabilities 15,000
Total Debits (What I Got) = 115,000
Total Credits (What I Gave Up)= 115,000

A502: Intangible Assets 19

Journalizing Goodwill

Any non-identifiable asset (things you “got” but accounting

doesn’t identify) is called “goodwill”:

Goodwill 35,000
Identifiable Assets 80,000
Cash 100,000
Identifiable Liabilities 15,000

A502: Intangible Assets 20

10
 So What is Goodwill?
• Things of value that accounting cannot identify
– Brand names, synergy etc.

• An overpayment by the acquiring company

A502: Intangible Assets 21

Recognizing “Use” of Goodwill

• Since accounting cannot identify the items that make
up goodwill, it struggles with identifying how they
are used up
• Current rules in U.S. say to assess once a year to
determine whether it is “impaired,” but no
systematic amortization of the asset.
• The basic idea is like any other asset impairment.
That is, do you have a probable future value that you
control from a past transaction? Computing that is
technical and follows a multiple step process.

A502: Intangible Assets 22

11
 Liabilities with a Focus on
Contingent Liabilities
Accounting 502
Session 7

Agenda
• Economics of Liabilities
• General Accounting for Liabilities
• Economics of Contingent Liabilities
• Accounting for Contingent Liabilities
• Measurement issues
• Management bias
• Bookkeeping mechanics

A502: Liabilities 2

2
 Economic Reality
• As firms undertake their business activities, they
often incur obligations to provide future value to
other entities. Usually this entails cash payments,
but it may be for goods or services.
• In other words,
– Do we owe others something?
– How much do we owe?

A502: Liabilities 3

Liabilities for Payments Due

Inventory Bought on Account
(1) Inventory 323,000
Accounts Payable 323,000

(2) Accounts Payable 323,000

Cash 323,000

Employee Wages Earned

(1) Wage Expense 8,000
Wages Payable 8,000

(2) Wages Payable 8,000

Cash 8,000
A502: Liabilities 4

4
 Liabilities for Goods and Services
A customer prepays $15,000 for a shipment of 1,000
shirts that costs us $8,500 to produce

Cash received
(1) Cash 15,000
Deferred Revenue 15,000

Shirts delivered
(2a) Deferred Revenue 15,000
Revenue 15,000
(2b) COGS 8,500
Inventory 8,500

A502: Liabilities 5

Longer-Lived Liabilities
• Many liabilities are incurred and/or paid over
multiple periods, often extending far into the future.
– Deferred Compensation, Bonds, Long-term Leases,
Pensions, Post-Employment Benefits, etc.
– Due to long time periods, accounting requires PV
calculation, which you will cover in finance
– These types of liabilities (and more) are covered in
accounting 564

A502: Liabilities 6

6
 Contingent Liabilities
• Economic Reality – an event occurs that is likely to
require a future economic sacrifice, but the extent or
amount is dependent on a future event
– In short, the primary event has occurred, but its full
economic impact is contingent on future events

A502: Liabilities 7

Economic Reality
• Contingent Liability
Management Management
Assesses Reassesses
Liability Liability

Probable Loss EOY Subsequent EOY Obligation

Event Occurs Event Fulfilled
Confirms Or
Loss Eliminated

A502: Liabilities 8

8
 Economic Reality
• Examples

– A chemical spill occurred, and it will take a year to

determine if it spreads

– A shoplifter claims he was hurt by store security and has

initiated a lawsuit

A502: Liabilities 9

Accounting for Contingent Liabilities

1) Is it likely we will need to make a future economic
sacrifice? Will the future event occur?
– Remote (unlikely)
– Reasonably possible
– Probable
2) Can we estimate the amount of the loss?

A502: Liabilities 10

10
 Contingent Liability Decision Tree

Disclose in notes Disclose in notes

Reasonably
Possible No
Will the future Probable Can it be
event occur? estimated?

Remote Yes Most likely

amount on
Do Nothing
Financial
Statements

A502: Liabilities 11

11

Measurement Issues
• Did an event happen?
– May be difficult to notice initial event

• Will the future event happen?

• How do I put a dollar amount on it?

A502: Liabilities 12

12
 Management Bias
• Want to believe in best outcomes
– “Manage this away”
• Concern about signal this sends to other parties in a
dispute
– Lawsuits, EPA, etc.
• Room to adjust over multiple periods where
incentives may vary

A502: Liabilities 13

13

Applying the Accounting

• A chemical spill occurs 10 days before year end.
• The company is told there is no need to take action now, but
there is a 90% chance a clean up will be required in six
months.
• The cost of the clean up is usually $100,000, but in ideal
conditions may only be $95,000.
• There is a small chance that a wet, warm winter could cause
the spill to spread further increasing the clean up costs to
$150,000.

A502: Liabilities 14

14
 Contingent Liability
Assume all works out as expected – $100,000 cost

Balance Sheet Income Statement

Cash Environmental Liability Environmental Expense

Year (BB) 800,000  Assume
1 0 100,000 (1) 100,000 (1)

Environmental Expense
Year (EB) 800,000 100,000 (EB)
2
100,000 (2) (2) 100,000 0

(EB) 700,000 0 (EB)

A502: Liabilities 15

15

Journalizing Contingency

Year 1) Environmental Expense 100,000

Environmental Liability 100,000

Year 2) Environmental Liability 100,000

Cash 100,000

A502: Liabilities 16

16
 Contingent Liability
Worst outcome occurs – $150,000 cost

Balance Sheet Income Statement

Cash Environmental Liability Environmental Expense

Year (BB) 800,000  Assume (1)
1 0 100,000 (1) 100,000

Environmental Expense
Year (EB) 800,000 100,000 (EB)
2
150,000 (2) (2) 100,000 (2) 50,000

(EB) 650,000 0 (EB)

A502: Liabilities 17

17

Journalizing Contingency

Year 1 Environmental Exp. 100,000

Environmental Liability 100,000

Year 2 Environmental Liability 100,000

Environmental Exp. 50,000
Cash 150,000

A502: Liabilities 18

18
 Contingent Liability
Best outcome occurs – $95,000 cost

Balance Sheet Income Statement

Cash Environmental Liability Environmental Expense

Year (BB)
1 800,000  Assume
0 100,000 (1) (1) 100,000

Environmental Expense
Year (EB) 800,000 100,000 (EB)
2
95,000 (2) (2) 100,000 5,000 (2)

(EB) 705,000 0 (EB)

A502: Liabilities 19

19

Journalizing Contingency

Year 1) Environmental Expense 100,000

Environmental Liability 100,000

Year 2) Environmental Liability 100,000

Cash 95,000
Environmental Expense 5,000

A502: Liabilities 20

20
 Asset Review

Accounting 502

Underlying Principles
(groundhog day in accounting)

• Cash can be misleading – cash is important

and often helps alert us that something has
happened, but focusing on it alone is often
misleading.
• Accounting requires forward looking –“future
value”, “future sacrifice” “earned” “realized”
etc. all require forecasting into the future

A502: Assets − A Review 2

2
 Underlying Principles
(groundhog day in accounting)
• Accounting reflects actions taken– the
historical costs convention measures what the
company did, providing a “stewardship” view
of actions taken
• Accounting requires reassessing – forecasts
may change, uses may change
• Accounting has measurement error and bias –
they are inherent in forecasting, particularly if
others use the forecasts

A502: Assets − A Review 3

What is an Asset?
Asset: The definition (per FASB)
– A present right of an entity to an economic benefit

Asset: Other Useful definitions

– Probable future economic benefits obtained or
controlled by the firm as a result of past transactions or
events
– Current items of value being held with the intention of
creating even more value in the future
– A future expense (when it creates value)
A502: Assets − A Review 4

4
 The Life Cycle of A Typical Asset
• An expenditure is assessed to determine whether it meets the
criteria of an asset
• If so, the acquired/incurred costs are capitalized as an asset on the
accounting books
• It is treated as an expense when the company uses up the value –
estimates are often required
– Note that some items are used and reduced in value, but the value is
capitalized as creating another asset (usually PP&E used to create
inventory)
• The asset is reassessed over time for adjustments in estimates –
these may be changes in expensing going forward or an impairment
• It is eventually disposed of and a gain/loss may be calculated and
placed on the income statement

A502: Assets − A Review 5

How Do You Get Assets?

1) Transform one asset (cash) into
another asset:
Inventory 100,000
Cash 100,000

2) Incur a liability to get an asset:

Inventory 100,000
Accounts Payable 100,000

3) Transform one asset (often PPE) to

another asset:
Inventory 100,000
Accum. Deprec. – PP&E 100,000
A502: Assets − A Review 6

6
 What Expenditures are Treated as
Assets?
Initially recorded: As the Asset is Used
• All costs to acquire and • Costs which extend the
prepare for use useful life beyond the initial
• Easy when buying “finished” expectation
item from outside • Costs which expand the
• Usually also incur internal capability beyond the
costs while get assets original purpose
prepared for use – set up,
additional modifications,
manufacturing item etc.

A502: Assets − A Review 7

Recognizing Expenses
• Matching principle
– Expenses should be recognized in the same period
as the associated revenues
• Think about resources consumed to generate
that revenue. Three heuristics that might help
– Direct association
– Systematic estimation
– Immediate recognition

A502: Assets − A Review 8

8
 Impairments, Write offs, Write Downs
• Each period, we must assess our assets to
determine whether they still have a net realizable
value equal to or greater than the carrying value
on our accounting books
– Value may have declined, but if still above “book
value” no accounting impairment

• If NRV is below book value AND it is a permanent

impairment, we need to reduce the value.

A502: Assets − A Review 9

Gains and Losses

• Accounting for asset usage requires several
estimates, such as salvage value and useful life.

• When we dispose of an item, we compare its net

book value to amounts received (if any) on the
disposal
– Amounts greater than book value are a “gain” (Income
Statement)
– Amounts less than book value are a “loss” (Income
Statement)

A502: Assets − A Review 10

10
 Uncertainty and Asset Accounting
Uncertainty
in composition Goodwill
(cost, value)

Intangibles

Inventory
PP&E
Accounts
receivable

Uncertainty
in timing of usage
A502: Assets − A Review 11

11
 Statement of Cash Flows

Accounting 502
Session 9

Agenda
• Review of Accrual Accounting

• Why Does Cash Get Its Own Statement?

• Direct Cash Flows Statement

• Indirect Cash Flows Statement

A502: Cash Flow Statements 2

1
 Accrual Accounting
Accrual Accounting: Accounting method that records
revenues and expenses when they are incurred,
regardless of when cash is exchanged.
– We determine ‘incurred’ based on the economics of the
firm when possible

Accounting = reality + measurement error + bias

A502: Cash Flow Statements 3

Accrual Accounting Statements

Balance Sheet Income Statement
• Where we stand today • Value created this period
• A picture of what we have, • Details of value generated
what we owe and what is by firm operations and the
“left over” for owners related costs (value use) to
generate those inflows

• Based on informed • Based on informed

estimates estimates

A502: Cash Flow Statements 4

2
 Three Categories of Cash Flows
• Cash flows from Operating Activities – “Operating activities include all
transactions and other events that are not defined as investing or financing
activities…Operating activities generally involve producing and delivering
goods and providing services…generally the cash effects of transactions and
other events that enter into the determination of net income.”

• Cash flows from Investing Activities – “Investing activities include

making and collecting loans and acquiring and disposing of debt or equity
instruments and property, plant, and equipment...”

• Cash flows from Financing Activities – “Financing activities include

obtaining resources from owners and providing them with a return on, and a
return of, their investment; borrowing money and repaying amounts
borrowed…from creditors on long-term credit.”

- Statement of Financial Accounting Standards No. 95

A502: Cash Flow Statements 5

Cash Flows from Operating Activities

• Cash receipts from sales of goods or services
• Cash payments to suppliers or employees
• Cash receipts from dividends or interests earned
• Cash flows related to lawsuit settlements, charitable
contributions etc.
• Cash payments to lenders for interest (in the US, under
IFRS could be in several categories)

A502: Cash Flow Statements 6

3
 Cash Flows from Investing Activities
• Cash flows related to purchase or sale of PP&E
• Cash flows related to the purchase or sale of long-
lived intangibles
• Cash flows related to the purchase or sale of
investments (e.g., marketable securities)
• Cash flows related to lending money to borrowers or
collecting money from borrowers

A502: Cash Flow Statements 7

Cash Flows from Financing Activities

• Cash flows related to the issuance or repurchase of
common stock
• Dividends paid to owners
• Cash flows related to the issuance of (or payments
on) bonds or notes payable
– But in the US, not the payments of interest – remember
those are in the operating section, but may differ under
IFRS

A502: Cash Flow Statements 8

4
 A&E Shirts Cash Transactions
Cash
(1) 215
120 (2)
48 (3)
(6a) 102
142 (6b)
(7) 15
17 (10)
(EB) 5
A502: Cash Flow Statements 9

A&E Shirts – Cash Transactions

Trans. # Description Category?
(O, I, F)
1 $215,000 cash contributed by owners

2 $120,000 cash used to prepay rent

3 $48,000 cash paid on equipment, $96,000 note payable

6a $102,000 cash collected on accounts receivable

6b $142,000 cash paid on accounts payable

7 $15,000 cash collected for shirts to be provided in future

10 $17,000 cash paid for dividends

A502: Cash Flow Statements 10

5
 A&E Shirts – Direct Cash Flow Statement
Cash Flows from Operating Activities
Receipts from Customers (102+15).. $117,000
Payments to suppliers…………………… (142,000)
Rent Payments……………………………… (120,000)
Net Cash From Operations…………. ($145,000)
Cash Flows from Investing Activities
Cash for Equipment………………………. $(48,000)
Net Cash from Investing……………. ($48,000)
Cash from Financing Activities
Stock Issuance……………………………… $215,000
Dividend Payment ………………………. (17,000)
Net Cash from Financing…………. $198,000
Net Change in Cash…………………………. $5,000
+Beginning Balance…………………......... 0
Ending Balance……………………………….. $5,000
11

Indirect Cash Flow Statement

• The cash flows from operating activities section is presented by
starting with net income and reconciling it to cash from operations
• Put another way, the statement starts with the accrual accounting
measure of value creation and reconciles it to the cash measure of
value creation

• NOTE: The cash from operations number does not change, this is
just an alternative presentation

A502: Cash Flow Statements 12

6
 Two Types of Cash Flow Statements
• Cash flow from operating activities
– Direct Method: List separately the cash
Same CFO number,
paid/received from operating activities but different approach
– Indirect Method: Reconcile Net Income to CFO

• Cash flow from investing activities

– List separately the cash paid/received for each
investing item
Exact same
• Cash flow from financing activities (direct)approach
– List separately the cash paid/received for each
financing item

*Cash from the three categories sum to the change in cash for the year:
Beginning cash balance + change in cash = Ending cash balance
A502: Cash Flow Statements 13

Indirect Cash Flow Statement

Net Income
Plus: Non-cash expenses that are in Net Income
Cash receipts that are not in Net Income
Losses that are in Net Income

Less: Non-cash revenues that are in Net Income

Cash expenditures that are not in Net Income
Gains that are in Net Income

Cash Flows from Operating Activities

A502: Cash Flow Statements 14

7
 Cash Flow Statement – Indirect Method
• Example
– Company has $1,000 in sales, where the sales were collected in cash
during the period.
– Company spent $800 during the period to generate the sales for that
period. This includes costs for employee wages, inventory, rent, etc.

Item Net Income CF from Operations

$1,000 Cash Sales $1,000 $1,000 Cash Inflow

$ 800 Cash Expenses $ - 800 $ - 800 Cash Outflow
$ 200 $ 200

*Do we need to reconcile NI to CFO? No, because there is no difference!

15

Cash Flow Statement – Indirect Method

However, in reality, there will be differences--such as items that impact NI, but
not cash flow. For example, assume that the firm has an asset that it depreciates.
Item Net Income CF from Operations
$1,000 Cash Sales $1,000 $1,000 Cash Inflow
$ 800 Cash Expenses $ - 800 $ - 800 Cash Outflow
$ 150 Depreciation Exp $ - 150 - N/A -
$ 50 $ 200

*So, the operating section of the Cash Flow Statement is as follows:

Operating Section of Cash Flow Statement (Indirect Method)

Net Income $ 50
Adjustments to reconcile NI to CFO:
Depreciation Expense $ + 150
Cash flow from operations $ 200
16

8
 Cash Flow Statement – Indirect Method
Moreover, there may be operating cash inflows/outflows that do not impact net
income. For example, a company may prepay rent (i.e., prepaid expense).
Item Net Income CF from Operations
$1,000 Cash Sales $1,000 $1,000 Cash Inflow
$ 800 Cash Expenses $ - 800 $ - 800 Cash Outflow
Prepayment of rent for $70 - N/A- $ - 70 Cash Outflow
$ 200 $ 130
*So, the operating section of the Cash Flow Statement is as follows:

Operating Section of Cash Flow Statement (Indirect Method)

Net Income $ 200
Adjustments to reconcile NI to CFO:
Increase in prepaid expense (current asset) $ - 70
Cash flow from operations $ 130

17

Cash Flow Statement – Indirect Method

If the company had both of these items, then we would record the following:
Item Net Income CF from Operations
$1,000 Cash Sales $1,000 $1,000 Cash Inflow
$ 800 Cash Expenses $ - 800 $ - 800 Cash Outflow
Depreciation expense $150 $ - 150 - N/A-
Prepayment of rent for $70 - N/A- $ - 70 Cash Outflow
$ 50 $ 130
*So, the operating section of the Cash Flow Statement is as follows:

Operating Section of Cash Flow Statement (Indirect Method)

Net Income $ 50
Adjustments to reconcile NI to CFO:
Depreciation expense $ + 150
Increase in prepaid expense (current asset) $ - 70
Cash flow from operations $ 130
18

9
 Changes in Working Capital Approach
• In the Net Income/Cash Flows from Operations reconciliation in
the operating section of the cash flow statement, a ‘shortcut’ is
generally used for net working capital. This short cut implicitly
assumes that any change in net working capital was a cash
based transaction.
– Increases (decreases) in current assets (liability) are subtracted from Net
Income to arrive at Cash Flows from Operations
– Decreases (increases) in current assets (liability) are added to Net Income
to arrive at Cash Flows from Operations

A502: Cash Flow Statements 19

A&E Shirts – Indirect Cash Flow Statement

Cash Flows from Operating Activities
Net Income………………………………….. $47,000
Add:
Depreciation………………………………. $3,000
Increase in Wage Payable………….. 8,000
Increase in Unearned Revenue….. 15,000
Increase in Accounts Payable…..… 181,000 207,000
Subtract:
Increase in Prepaid Rent…….……… $110,000
Increase in Accounts Receivable… 238,000
Increase in Inventory………………... 51,000 (399,000)
Net Cash Flows from Operations…….. ($145,000)
Cash Flows from Investing Activities
Cash for Equipment……………………. $(48,000)
Net Cash Flows from Investing……….. (48,000)
Cash Flows from Financing Activities
Stock Issuance…………………………… $215,000
Dividend Payment …………………….. (17,000)
Net Cash Flows from Financing………. 198,000
Net Change in Cash……………………….. $5,000
+Beginning Balance………………………. 0
20
Ending Balance……………………………… $5,000

10
 Changes in Working Capital Approach
• In practice, the changes in working capital approach is used by
most firms
• It works for most transactions because an erroneous
assumption about cash in one working capital account is
generally offset by another working account.
• But it will fail if a current asset is financed by a long term
liability or if a long term asset is financed by a current liability
(that is, a working capital item changes due to a transaction
that involves a non-working capital item)
– Purchase inventory via a note payable
– Buy PP&E with a short term accounts payable

A502: Cash Flow Statements 21

11
 Ratios

Accounting 502
Session 10

The Goal of Accounting

Accounting provides information to
decision-makers

A502 Financial Accounting: Overview

1
 Reaching the Goal
• Ratios are a great tool to help in providing
those insights.

• Best used in combination with a focused set of

questions or ideas about the firm’s value
creating functions – that is, used to confirm or
refute a hypothesis.

A502: Ratios 3

How to Use Ratios

• Comparing a firm to itself over time

• Comparing across firms

• Comparing a firm to its industry

• Comparing across industries

A502: Ratios 4

2
 How to Use Ratios
• The most important thing about using ratios is
that you must

Think
Like any tool, it is important to choose the
correct tool for the job, to understand why
you are using it and what its purpose is

A502: Ratios 5

Many Formulas, One Name

• Acid Ratio

Cash+ Marketable Securities + Accounts Receivable

Current Liabilities

Cash+ Marketable Securities

Current Liabilities

A502: Ratios 6

3
 Many Names, One Formula
• Quick Ratio
• Acid Ratio
• Liquid Ratio

Cash+ Marketable Securities + Accounts Receivable

Current Liabilities

A502: Ratios 7

Some Common Myths About Ratios

• There is a set of ratios that should be used to
answer all questions about a company
• Each question can be answered by a specific
ratio, you just need the list

• Ratios make firms comparable across all

attributes (size, industry, etc.)
• Ratios can be used in place of understanding
accounting
A502: Ratios 8

4
 How to Use Ratios
• Regardless of the question being answered, the
power of ratios is the way they combine information
to provide a greater insight into the firm’s operations
• Often these combinations draw from multiple
financial statements, thus putting together
information about the current status and the value
creation
• Other times they stay within one statement, but help
us understand the relations within that statement

A502: Ratios 9

Types of Ratios
• It is useful to think of components of ratios as
either “flow” numbers or “stock” numbers
– A flow number represents something that
changes over the period being examined, so it
generally comes from the income statement or
the cash flow statement
– A stock number represents a point-in-time view of
a position, so it generally comes from the balance
sheet

A502: Ratios 10

5
 Flow over Stock
• Many ratios are created by combining a flow
number over a stock number.
• The economic interpretation is to think of how
much flow (usually value) the firm generated
for the stock they had during the period
• Can be thought of as a “Return on [stock]”
measure
• Examples: ROE, ROA, ROIC, etc.

A502: Ratios 11

Stock over Flow

• Some ratios are created by combining a stock
number over a flow number.
• The economic interpretation is to think of
how much time it takes the firm to turn its
stock with respect to a flow
• Examples: Days of Inventory, Days Receivable

A502: Ratios 12

6
 Flow over Flow
• Another common calculation is to compare
one flow to another flow
• The economic interpretation is to think of how
one flow relates to the other, either by
examining how much of a flow is caused by a
component or to think of how much of a flow
is retained after considering other flows
• Can be thought of as a “relative flow”
• Examples: GM, ROS, Operating margin
A502: Ratios 13

Stock over Stock

• Many ratios examine the relation of one stock
to another
• The economic interpretation is to think of
comparing how much of an item of value you
have relative to related claims or to
understand the relative composition of an
aggregate stock number
• Examples: Debt to Equity, Quick Ratio,
Tangible Asset Ratio

A502: Ratios 14

7
 Using Sets of Ratios
• Ratios are generally most powerful if used in
sets to provide a more complete economic
picture of the firm
• Often this means calculating multiple ratios of
different types and understanding the pattern
from the set of ratios
• However, it also can mean taking one ratio
and decomposing it into other parts to better
understand it

A502: Ratios 15

The DuPont Analysis

• One well known and very useful
decomposition is the DuPont formula, which
explains ROE through a set of component parts

ROE = Income ÷ Equity

ROS x Asset Utilization x Leverage

= Income ÷ Sales = Sales ÷ Assets = Assets ÷ Equity

A502: Ratios 16

8
 Final Review

Accounting 502

Accrual Accounting
• A method of accounting that recognizes
expenses when incurred and revenue when
earned rather than when cash payment is made
or received.
– The goal of the accrual process is to capture the
economic reality of the firm. It struggles with
measurement error, which creates opportunity for
bias.

1
 Insert Asset Review Slides Here
• Use the asset review slides provided in session
seven

A502: Assets − A Review 3

What is a Liability?
• Liability Concept Statement 6 (old, training wheels)
– Probable future economic sacrifices arising from present
obligations as a result of past transactions or events.
• Liability Concept Statement 8 (new, “concise”)
– A present obligation of an entity to transfer an
economic benefit

Liability: Other Useful definitions

– A promise to pay cash or give up value in the future
– An obligation not yet fulfilled

2
 The Life Cycle of a Liability
• A liability occurs when an economic obligation is
incurred.
• The magnitude of the estimated obligation may be
reassessed at various points in time.
– Adjustments will impact the balance sheet and likely the
income statement through expenses.
• Economic value, usually cash, is given up to fulfill that
obligation. The liability is removed from the books.
– If more or less value is used then expected (booked), it
may impact the income statement through expenses if
your prior estimate was incorrect.

A502: Assets − A Review 5

How Do You Get Liabilities?

1) Purchase (or create) an item:
Inventory 100,000
Accounts Payable 100,000
2) Incur an expense:
Wages Expense 100,000
Wages Payable 100,000
3) Incur an obligation for a good or
service:
Cash 100,000
Deferred Revenue 100,000

3
 What is Stockholders’ Equity?
Equity: The definition
– Money either contributed directly by shareholders
or value earned by firm operations, but not yet
distributed
Equity: Other Useful definitions
– The excess of assets over liabilities
– The residual value after fulfilling all claims

How Do You Get Stockholders’ Equity?

1) Direct contributions:
Cash 150,000
Contributed Capital 150,000

2) Firm generates value:

Net Income (income summary) 27,000
Retained Earnings 27,000

4
 Cash Flow Statement - Mechanics
• Statement indicates how a company generates cash and uses cash
– Complements accrual statements (Balance Sheet and Income Statement)
– Provides information about a company’s liquidity, ability to fund PP&E
growth from operations, and main drivers of cash changes for the period
• Three categories: Operating, Investing and Financing
• Format of statement: Cash from the three categories sum to the
change in cash on the balance sheet
change in cash + beginning cash = ending cash

• Direct method just states cash paid/received

– investing and financing sections are always direct
• Indirect method reconciles accrual view to cash view
– NI reconciled to Cash Flow from Operations (CFO)

Cash Flow Statement – Reading It

1) Review three categories
i) CFO : +, trend?
ii) CFI: -, trend?
iii) Does CFO cover CFI? Investing at least at replacement relative to
depreciation?
iv) CFF: Could go either way
2) Getting into details: let Willie Sutton be your guide
i) Start at bottom, so financing first: shifting structure?
ii) Investing next : what are you buying? Tie to financing?
iii) Operating : trends, relation with other categories?
3) Make lists of questions so you can follow up.

10

5
 Ratio Analysis
• Focus on the process. Must combine understanding of
accounting with thoughtful application and analyses of
ratios created
– That is, given some financial information and a hypothesis or
question, be able to provide a thoughtful discussion as to (1)
why you chose or created a particular ratio, (2) its
interpretation, and (3) any adjustments to the financial
statement items that may be necessary to conduct the “best”
analysis
• ROE and DuPont
– NI/Equity = NI/Sales*Sales/Assets*Assets/Equity
• Names aren’t important, understanding is
11

What Have You Learned?

• As you study, reflect on what you can do now
that you could not do before this course.
– Try to remember what your knowledge was in the
end of August.

A502: Assets − A Review 12

6
 What’s Next?
• The Basics …
– A502
• The financial statements
• Recording and analyzing transactions
• Accounting concepts illustrated with basic transactions
– A564 (Corporate Financial Reporting)
• Accounting for important and common transactions
– Leases, ownership, pensions, income taxes, and so on
• Measurement and disclosure of economic transactions,
working backwards from company financial statements

13

What’s Next?
• Understanding the flow of financial information in the markets
– A618: Financial communication, IPOs, managing investors, activist
investors, acquisitions etc.

• Analyzing Financial Statements

– A711: Analyzing statements, ratios, credit analysis
– A713: Forecasting, additional ratios, valuation

• Want to be an Analyst, M&A Advisor, CFO, I-banker, … (or a CPA)?

– A565: Financial instruments, derivatives, FX
– A625: Consolidations, partnerships, government
– A560: Taxation and managerial decisions
– A561,A620: Federal Tax Code

14

7
 And so,
• Exam rooms will be posted on Canvas
• Good luck on the exam…remember, it is only an exam
• Thanks for helping make the term a great learning
experience and fun (at least for Heidi and Greg)
• Q&A time or spend it how you want

15