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Accounting Introduction o Foundational accounting principles that we should know o Exam: in class, 15 questions, MC, pass/fail. Half of questions are problem based, and half are concepts and principles. Basic math for the problem based questions. OPEN BOOK, OPEN NOTE, OPEN LAPTOP (MC will be on the laptop) no accounting on the final exam. Calculators are allowed. o Accounting is a way of organizing financial information (reporting entitys financial condition and performance in a way thats easy to understand how the company is doing) telling a story about the entity if you were to observe them. o Finance is separate study of how people allocate scarce resources over time and in the presence of uncertainty. Cost of financial decisions spread out over time. Because they are spread out over time, they involve uncertainty. Finance comes down to manipulation of the basic concept of the time value of money Time Value of Money o Intertemporal how to compare the value of money that comes in at a different time. Accounting Problem 1 o Why not take the 10 million right away why take the 6 million right away? Money in the future is worth less than now. Present money is worth more than future money. Why take the money right now? Because it has more utility and you can do more with it. Money now is worth more than money later Risk that you might not get your money later on. Whats the present value of 10 million dollars right now? OR what is the future value of the present value of 6 million right now First thing we need to know is the interest rate. Lets assume a 10% interest rate You earn interest not just on the present interest but on the interest each year too You can also do this by compounding (daily, annually, monthly) Accounting o Can create a lot of perverse incentives, because public entities are judged by their financial statements, they would try to manipulate these to make the entities look better. o Like in Mega-Mega, when do you want the 6mil to show up on your books? if you take it right away as lump sum, itll show up as an asset, versus if u take out a loan, itll show up as a debt. o Financial Statements product of accounting Balance Sheet Snapshot of entitys financial condition as of a specific date. As of that date, BS summarizes obligations, assets, liabilities, and anything thats left over. Think of it as a photo or picture. Will include snapshots from two different periods, (end of 12/04 and end of 12/05 (for comparison)) Problem #5 (Joyce James Problem) o Will give her an overall picture of her financial resources. How do we go about to show what she earned and spend. Balance sheets are organized into 3 accounts: assets, liabilities, and owners equity. o Asset: probable future economic benefit, that is owned or controlled by an entity. Create subaccounts like cash or equipment and be consistent Every time you have a transaction put an identifier on it such as #1 Always going to be doing two entries on either side because they must balance out

Parenthesis signify decrease Normally not a lot of direct entries for equity so when things simply cannot be assets they go down in equity. Double entry can and most likely will happen on one side such as a decrease in cash and increase in book section of assets. If J goes to graduate school and spends 5000 in cash on expenses Whats carries an future probable economic benefit in order for it to be an asset is problematic if you cant find it as an asset then decrease it as equity. You can have negative equity because it has to balance somehow. (this is called negative net worth) Equation still has to even out even if you get a negative equity at the end of the day. Pay attention to definitions of assets and liabilities. This is why firms have the incentive to fudge around with the definitions. When in doubt try to understate the financial picture of an entity. If you doubt or are unsure if something is an asset dont put it as an asset but if your unsure if something is a LIABILITY put it as a LIABILITY. Why record books as 2000 if the resale value is less than 2000? Because as of this point in time these books are worth 2000 at the time they were bought. The best evidence of what something is worth is what you bought it for, so you show it at the time of when you bought it or at cost COST PRINCIPLE (historical costs) This keeps you from tinkering with the numbers in an environment of rising prices where one may be tempted to show more assets but using the cost principle is more conservative and more safe. And less costly to resurvey or to find out the market value at any given point in time other than at the time of the cost. Monetary unit principle we record everything on our books in a common unit (we dont record saying 5 books 12 chairs 1 horse etc) but if we record in one unit then its easy to compare later on. Especially when you are involved in legal proceedings then you want to look at her financial status. o Liability: probable economic future loss or sacrifice which you as an entity are obligated to pay. i.e., a loan. o Equity: whats left after all assets and liabilities are carried out. o Assets + Liability = Equity o Assets = Liability + Equity What happens if we increase assets and dont do anything else? 100(a) = L (0) + Equity(100) 99(a) = L (0) + Equity (99) if you decrease your assets (and then is no change in liabilities then your equity will decrease) Income Statement Provides summary of financial activity across time. Records all of your revenues and expenses over a period of time. Designed to be more of a movie instead of a snapshot. Shows whether over time you incurred a profit or loss. Same thing as a profit and loss statement. Summary of Cash Flows

Focuses on cash flows. Tracks use of cash over time. Shows the total that is coming in and coming out. Amount of cash wont always correspond with your income because income wont always depend on cash coming in. Page 6 Asset Accounts Cash self explanatory Account Receivable Money that should be coming in for services rendered or products sold. Money that needs to be collected from customers. Carries a future economic benefit. Inventory goods purchased or produced that you hold for sale. The thing that your business makes in order to generate money. This is an asset because it will be sold as a probable future economic benefit. Prepaid Expenses - utilities (prepaying rent or utilities) amounts paid to others for goods or services that you have not yet enjoyed. This also has a future economic benefit the right to use for a number of years, etc. The order in which these assets are listed is in order of their liquidity the ability to turn that stuff into cash quickly. Cash is obviously of highest liquid and then accounts receivable are next up and then inventory, prepaid expenses, etc. things like property, plant, and equipment wont be liquidated as easily. Page 7 Liability Accounts Current liabilities payments that the company is engaged in for running the company. Account Payable - Payment that the company owes for goods or services received but the company has not yet paid for. Accrued Expenses money you owe for expenses that you incurred but the difference is that they havent been billed to you yet. Income Tax Liability self explanatory Short term notes payable loans, notes, etc Long term notes payable self explanatory Page 7 Equity Capital stock what shareholders paid in when company first sold stock Retained earnings equity or profits the company held on to as reinvested in the company. Income Statements (track financial performance over time) these tell you at the end of the day, whether you made a profit or not by dividing things into two categories. REVENUES AND EXPENSES Revenues increases in equity that result from operations during an accounting period and from central operations. Increases that result from operations (manufacture and sale of your inventory or goods or services) Expenses decreases in equity that come from operations in an accounting period, i.e., from the manufacturing or selling your goods. If then you have a profit (revenues exceeding expenses) that means that your equity by definition will have gone up. Income statement tracks changes in equity which means that at the end of the day any income or profit youve shown will have to reflect a corresponding increase on your balance sheet. The definitions such as the categories of assets are also important on the income statement. Not all changes in equity will meet the definition of revenue or expense. Recognize these expenses and revenues are recorded in the period in which they were made. (cost principle) Problem 7 (accounting supplement) cash accounting is misleading and general accounting principles are based on ACCRUAL accounting recognizes revenue and expense independent of when cash is coming in

and out) does this based on matching principle which is a principal of accrual accounting and says revenue should be allocated to the period in which effort was expended in generating it. Recognize revenue when you finally sell something or when you deliver the service NOT when you are paid. Expenses should be allocated to the period in which they contributed to the revenue or income generation. Joes 500 is listed under REVENUE in the income statement Gills 600 is listed under REVENUE in the income statement (doesnt matter when he gets paid for it) Joes 200 for gas is listed as an EXPENSE because he uses it up Gills 250 in cash for gas is listed as an EXPENSE because he uses it up too. based on ACCRUAL ACCOUNTING Gill is generating more revenue o Problem 6 (accounting supplement) after you account for it under A = L + E (and when equity is supposed to go up) you have to ask if the definition of the transaction meets the definition of revenue or expense. #6.1 this is a gift so while cash and equity goes up by $1000 this is neither expense or revenue unless this is the regular way they raised money was by donation then it would account for as revenue #6.2 asset for asset swap (cash goes down by $1000 and costumes go up by $1000) #6.3 Cash goes up by $3000 and equity goes up by 3000 so this also goes up in the revenue column by $3000 #6.4 when you do balance sheet + income statement, you dont need to do the matching on the balance sheet side with two number showings until you close the books #6.5 under the matching principle in accrual system, you recognize things when you earn them. How else can you account for these advance sales? Well now they have a 1000 dollars but now they also have an obligation to perform so account it as a liability under a subaccount called Deferred Income deferred income: Can also be known as deferred revenue. #6.6 Lets say in the next year they put on the plays for which they sold the advanced tickets? Remove it from deferred income because its no longer an obligation since you performed the action already. Goes down by 1000 Recognize it now as an equity but under the revenue column since its clearly an equity, and not an asset AND not an expense #6.7 lets say in the previous accounting year u used up the right to be in the auditorium the year before and didnt pay the rent (you used the auditorium but didnt pay the 1000/ year rent) when you do this, you are consuming an asset that goes toward your central obligation, this is an expense. So account for it under expense and under accrued expense in the liability category. Once you pay the accrued expense, your cash goes down and accrued expense goes down. How do we reflect used costumes on the books before we close out the books? Depreciation is a way of allocating the cost of a fixed asset over its useful life. Show over the life of the asset that you are using it up and that it doesnt last forever. We want to match as closely as possible to the period in which the truck was used to accrue income. Depreciation applies to goods that are used up in the course of your business and its not that its a tangible asset but applies to anything with a fixed useful life that can be used up in the course of your business. o 1 identify what on here is a candidate for depreciation, which has a fixed useful life? Costumes YES cash NO

o 2- one of the few things that you have to remember to do at the end of every accounting year. Look at all your fixed assets and depreciate them for that year before you close the books o 3 whats the expected useful life of each fixed asset? How do we do it? o 1 try to figure out the market value of all of our assets OR o 2 if costumes have a useful life of 4 years, so every year take out an equal amount, so depreciate by of 4000. Depreciate it by 1000. So costumes go down 1000 and if nothing else but equity goes down then ask if its a revenue or expense? Its a depreciation expense and you put a 1000 there. Things that are expensed at normal course of business is recorded as positive in the expense column, but what is purely bad luck is recorded in the Equity. Problem # 7.1 add 500 in cash and 500 in rev Problem #7.2 add 600 (sent out bill for 600) to AR and 600 to revenue (because you recognize it when you earn it) Problem # 7.3 add 200 to gas column because it was bought on credit and add 200 to liability under AP by 200 Problem #7.4 250 for gas goes up in gas column and down in cash Problem #7.5 when they use up the 200 in gas, they also use it as an expense so put 200 under expense Proble #7.6 use up 250 in gas so take it out of gas column and put it into expense Problem #7.7 you want to pay off 200 from accounts payable so you take it out of there and take it out of cash Problem 7.8 we get paid the 600 we are owed so we take it out of accounts receivable and put it into cash Problem 7.9 we take out a 10000 loan so we put it under LOAN in liabilities and put it under CASH as well Problem 7.10 we buy a truck for 10000, minus cash for 10000 and add an equipment column and put 10000 there. Problem 7.11 before we close the books we want to find the depreciation value of the truck, so if the truck is used for 5 years and is worth 10000 so 1/5 of it is 2000. Add depreciation expense column under EXPENSE and then add everything up. ASSETS should EQUAL LIABILITIES + EQUITIES(Exp+Rev)

o Notes Always identify what your fixed assets are and what is their useful life. Conventions are taken from IRS rules. He will tell us what the useful life is. What if at the end, the truck is worth 2000: instead of 10,000 you start with 8,000 Costs of installation is treated as part of capitalization. What happens if you spend money to repair the machine later on. Does it make it valued more? If the repair makes it last longer then you can add it to the cost of the machine and then the useful life is higher. Diff methods for depreciating what we did is the straight line method. But there are other methods, like depreciating front load, but we will always do the straight line method. Amortization basically means the same thing as depreciation. Applies to intangible assets more than tangible. Notice the incentive structure that problem 7 creates. If you want to show high income, what are you going to want to do in terms of expense? Try to minimize the expenses which means we try to do more asset for asset swaps than to show it as an expense right away. The fewer expenses you have the better your income

looks. When the taxman comes, you want to show as many expenses as possible. YOU CAN DO THIS. The relationship in general between the income statement (rev/exp) you might want to depreciate a lot when you want to keep taxes down. Depending on whether you want to show profit or loss, then you would reflect that in equity column. Income Statement (page 8) o Sales Revenue o Cost of goods sold expense o Gross Margin shows how efficient theyve been in their core operation (profit from manufacturing process) o Operating Expenses things that cant be directly tied into the COGS (maintenance on the building , HR, Rent) o Depreciation expenses fixed assets that depreciate (like trucks) o Operating earnings how efficient they are in their overall operation, zooming out from just the core. o Interest expense- most business need to borrow money so counted as an expense. o Earning before income tax = before tax $$ o Income Tax Expense o NET INCOME income after all expenses put it in the equity column after you calculate it because it is the sum of revenue exp o When you issue a dividend, equity will directly decrease and cash will go down . Since you are taking it and giving it back to the owners. If they sold it for 50000 and if you add that to then its balanced. Problem 8 o 8.1 95% will follow through with pledges of 300000 but 5% wont. How do they account for pledges receivable? Under assets but where else? If what they do is earn pledges then it goes under rev or under the liability as deferred income since just like the advanced tickets, it was an obligation to protect the animals. OR under equity just like a gift but this is probably not right. Once you actually perform then you subtract it from deferred and put it into revenue but also take $75000 out of deferred income cuz thats what it cost to save the cat so take it out of deferred income and then put it on revenue. Bigger problem in doing it this way is that when people pledge the 300k then in return they get an ambiguous IOU and its hard to calculate what their obligation is worth. When they pledge, what they really get in return is just a promise to keep going so maybe the better way is to just record it as revenue. when pledges come in, recognize it as pledges receivable and as revenue. o 8.2 people start paying their pledges receivable so it goes down and cash goes up (asset for asset swap) o 8.3 if we are sure we wont get any more than 285000 from the P.R, then we take it down by 15, but we also record this as an expense even though we never had it in the first place (IS is supposed to show how efficient weve been for that year if we dont show this as an expense then we show it as if we got it even though we didnt) o 8.4 if we show JUST 285 as of the beginning in the period of pledges, that is still a misrepresentation since you actually got 300. o 8.5 if we show revenue right of the bat when we get the pledges receivable, then immediately we should go the expenses under the matching principle. o 8.6 as the pledges come in, right it off and show it as an expense. o Ipod recognizes an unexpected warranty as an expense. o 8.7 moving expenses 150k needs to be paid right away to get her to come. How??? There was a 5 year commitment for jane to stay on for 5 years Put 30 thousand in the first year because that is the worth of her work, just like we do with the truck (depreciating expense) so classify is a down in cash by 150

and a PPM as 150 and then each year you subtract 30 from PPM and add on 30 to exp. If she leaves, we have to show it as a loss, so PPM will go down by 120,000 and expense will go down by120,000. Is this a correct way to show the moving expenses (comparing her to a struck) An asset is a probably future economic benefit here if she has a firm commitment, then its firm to capitalize this as an intangible asset. But she can always leave early and her commitment is not firm, so you probably shouldnt do it this way but its not wrong to do it this way.

-FIFO/LIFO o Financial Ratios analysis of different ratio of items on a firms financial statement. i.e., ratio of assets to liabilities or liabilities to equity. Loan covenants will specify ratios that they cant abandon How will changes in accounting for inventory effect these ratios o Return on Assets ratio of income to assets o Liability to Surplus is ratio of liability to surplus equity. o Accounting for inventory - is similar conceptually but complicated in the sense of double entry. Inventory will show up as an asset and will be shown at the cost of when you purchased it historical cost. Factory which makes widgets and we make at a cost of 10 per piece and we make them for 200 dollars and we pay this at production in cash. Accounting for the production cash is being spent so cash down by 2000 and inventory is up by 2000 Lets say we sell 100 of them at 12 a piece so cash up by 1200 and revenue goes up by 1200 and then inventory and expense go down by 1000 Accounting for inventory involves sets of matching entries in order to show how efficient are being, how costly is out profit margin is, what is happening to our assets as we sell them and how much income we have at the end. What happens if we build more widgets and as we build them the costs are changing. If the prices change in the middle of production, then the same asset for asset swap occurs just with the new price this time. ($2000$2200) We sell 500 widgets but how do we know which widgets we sold (some cost less to make than others and profits will be more with the widgets that cost less than others) o Tag on each widget so we know when we sold each we know how much it cost to make. (specific identification of inventory) .alot of times this is not possible. o Two most common assumptions are assuming FIFO or LIFO o FIFO you assume that the first ones you made are the ones that you sold. With our above 500 widget example, we do this by looking at the first ones we made (first 200 are gone, so we take 200 from the second as well, and then 100 from the 3rd line) (2000,2200,1200)=$5400 and expense goes to 5400 If we sold them for $13/500 widgets so AR goes up by 6500 and 6500 goes in revenue Shows higher inventory balance and it shows more income and you might think thats good and it is good if thats your objective o LIFO you assume that the last ones you made are the first ones you sold If it was LIFO, then what changes is the value of the inventory that we sold.

o o o

Start with the last year of production $2600 200 widgets $2400 200 widgets $1100 100 widgets o $6100 shows smaller income and smaller income and this is good for tax purposes o whatever you show on your tax return, you have to show on your financials. So if its LIFO then its LIFO through out Problem 9 the energy cooperative (LIFO) o We cant do a precise calculation because we dont know the cost of fuel every time they purchase it but if they change form fifo to lifo the costs of production are rising that will make their income go down. o Their ROA ratio cant fall below 5% (net income over the total assets) 31/300 = 10.3% so if they switch from LIFO to FIFO you are selling more expensive assets first so at the end of the year you will be showing fewer assets on your books so assets will go down while income decrease. o If cost of fuel sold is $15000 more than what they are showing under FIFO so then assets will be lower because inventory will be lower. o Cost of fuel sold will increase by 15000 and net income will be lower by 15000 so 31-15 = 16000. So 16/285 = 6.5% o Lets say you are under 5% and the bank says you defaulted, this is just a technical assumption and If we go back to FIFO then we wont be at default. If the bank says LIFO more accurately reflects the true costs of your production since it shows how much your income takes you to make on the same day that you actually sold it so we actually think that LIFO does matter, the response is that no where in the contract does it say that LIFO has to be used o Liabilities to Surplus Before they make the change, what is the liability to surplus ratio? 200% (200/100) AFTER CHANGE to LIFO liabilities dont change (200 stays same) but the surplus goes down (from 100 to 85 because it goes down by 15 as per professors earlier assumption of 15000) (200/85) Make same arguments as above o Computers obsolete: If they write off $20000 of their computers so computers will go down by 20,000 in Assets and matching entry is expense by $20000 (expense is called depreciation of computers) So income will now be $11000 and total assets are now $280000 if ROA = (11/280 = 3.9%) violation of 5% If liability over equity = 200/80 = violation of 200% Assets will be recorded at historical costs and when you sell them , you make two sets of recordings, one set for revenue and one set for expense. (historical cost of the inventory) and inventory will also decrease and income statement will show how efficient youve been and there are two ways to do this FIFO/LIFO LIFO - When costs of production are increasing, then higher cost of goods sold expense and lower income and lower inventory. FIFO is opposite. Lower cost of goods sold and asset balance of inventory and income are higher. Problem 10: FIFO at book close $1900

o LIFO - at book close $1700 o Lets say we hold onto the books for a whiledo we have to depreciate? No we dont depreciate inventory. At some point your books will look out of wack because you dont depreciate. Lower of cots or market value is the term for recording this. Because LIFO and FIFO assumptions are important for manufacturing businesses they need to be clear in their financial statements what method they are using, per GAP Page 146 notes in the financial statement explain the gray areas and flags the judgments as they come up and define ambiguous terms. Will define what the company will use for their inventory in this section. o Summaries of Cash Flows Income statements are based on accrual accounting dont care and have nothing to do with specific cash. These are designed to show how efficient you are when you make a profit. You can derive it from the balance sheet but the SCF acts as an antidote and shows exactly what is happening with our cash and whether its hurting or helping our cash position. How are we managing our cash? Cash could mean dollars and also short term/overnight investments. Organized into 3 categories Cash flows from operating activities. (manufacturing process, sales revenue, paying taxes, paying interest, receipt of interest, Investing Activities: loans, repayment of loans, Financing Activities - financing activities, investing activities, short term/long term debt Cash flows from operating activities Accounts receivable increase (175000) this is what theyve credited to other people what theyre owed. By having our AR go up by 175000 last year, this means that we were 175000 poorer in cash. Inventory Increase 440,000 this means that it came from cash and they traded cash for inventory (means less cash) if inventory DECREASE then the cash would be HIGHER Depreciation expense - $260,000 we had an expense of consuming stuff to make end product, and we did this by using hard assets that we had on hand and we saved cash and didnt have to use it. used up part of our track instead of paying Prepaid expenses decrease - $25,000 prepaid expenses go down so they cashed in on some of their expenses that theyve built up and were able to keep the extra cash on hand. Accounts payable increase 105000, they didnt pay their bills so they saved cash Accrued expenses increase -$ 59,667 - they let some expenses build up and owe them but havent paid so they hold onto the cash. Income tax payable decrease - $12060 paid down their owed taxes and this is a cash decrease. Cash flows from investing activities Purch of property (-750000) less cash now CASH FLOWS FROM FINANCIAL ACTIVITIES The amount of money they got from short term loans went up so that the increased their cash positions and the same with the long term borrowing o Cash is significant because we need liquidity to meet obligations (interest, taxes, etc) how are we managing our cash? And at the end of the year if we dont have enough cash, then why is that? Too many receivables? o Outback Steakhouse p. 145 Inventory decreases cash goes up

Income taxes payable decreases so cash does down and from 2001 to 2002 the cash goes up cuz they didnt pay what they owed for income tax. o When your liabilities go up then cash is higher and when assets go up then cash is lower. Boundary Problems o Areas in accounting where judgment calls and shade of gray are especially common. Intangible assets Problem 11: jane finds a new way to save money and improve productivity . How to record this? Clearly this had value but you show it by decrease in expenses or depreciation. At the end of the year, our expenses will be million lower and profits millions higher. o Generally, this is the only way to recognize it but maybe we can also put in a footnote (but what does this include?) we could include these in historicial cost if these are traceable as historical cost. tracing historial cost is to avoid problems that we are thinking of now. Its hard to make these expenses concrete. Cant show R&D in here, it has to be clearly and precisely traceable. o But you can book an intangible asset as a historical cost (such as a cost of perfecting a filing to your patent application) this seems kind of wrong, and unfair but this is the way to do it. If you were to license a patent, then it would shown in revenues because they would be huge. o As for your invention, itll indirectly be shown in your expenses. ( if you buy the assets ) Problem 11.B: the company acquired patent for 5 million and can now show it as a negative cash in 5Mil and Patent Asset addition of 5Mil. If you buy an intangible asset at arms length, thn you can show it on your books. Problem 11.C company has a building and a patent and B comes along and says itll buy A for 5 mil and we think that the building is worth 500,000 and the patent is worth 3mil. And they pay 5mil for the whole company. Goodwill amount that company would pay over and above the value of the asset base is about roughly market approximation of the value of the loyalty and trust. (if something is left over) goodwill is recorded as an asset. At the end of the accounting term, anything with a fixed useful life has to be depreciated. o What to depreciate? Building, intangible assets dont last forever so we amortize it (the patent), the goodwill doesnt have a fixed useful life, so then do a yearly impairment test (market study to see if the value of this thing has gone down) thats only for things that have an indefinite useful life. Just because you think something is indefinite doesnt mean it is, you have to do this study. Contingent liabilities Liabilities where either the fact of liability or the amount is uncertain This is a risk of loss. How do u deal with this on FS? Whether something is a risk of loss is analyzed at the time of the claim accrual. If you are FATCAT and it is fairly certain (99%) that you will lose and will have to pay 10 million(problem 1), then book it as a liability. Amount of the liability would be 10 million. o An impending judgment is an example of a contingent liability What if there is a 40% chance of FATCAT losing? o If its probable then book it but if its reasonably possible then show it in a footnote. Probable is something likely to occur. What if its a 5% chance of losing? o if its remote then you dont have to do anything . Other Examples

o Warranties are also examples of contingent liability o Financial guarantee of someones loan and then they default. o These can raise issues because they arent certain to be repaid. What if your loss is absolutely probable but your damages are not determined. What can you do? o You cant reasonably estimate so put it in your footnotes. And when you do have a reasonable estimate of the numbers then you can book it. Footnote 11, page 157 o Litigation: they have a section that is subject to legal proceedings claims and liabilities. Audit Letter on 34 o We are the accounting firm auditing your client and are you aware of any other pending litigations and its not on the list that the firm gives you but you know of one. First call the client before you tell the accountant anything. Extraordinary items (income/expense) Definition of revenue and expense are increases and decreases in revenue that comes from central operation and there can be other revenue and expense that dont come from central operations where do these go on income statements o Page 8, Income Statement: extraordinary items are included in the operating earnings line in the income statement. Unusual and unlikely to occur in the future and unlikely to relate to core operations. Companies care what is above and below that line because they want their operating expenses to look good. So even if something is an operating expense, companies may put it as an extraordinary expense. o There might be a year that will be terrible anyway and lets just pile In as many of them as we can so that it doesnt look AS bad. o Look in the footnotes the same way you would for contingent liabilities to see what a big item is about. o Page 147 Unearned Revenue They are using it to mean deferred income. Can be used to talk about something that is extraordinary revenue. When people buy gift cards, this is unearned revenue. o Page 143 Income from operations: heres how efficient weve been and how

Institutional Legal Structure o There are judgment calls throughout accounting the ideas of the convention and rules is to provide as much of a known baseline for understanding the judgments that go into each financial statement so that FS actually means something o GAAP governs a lot of these conventions. They are a product of a bunch of institutional inputs. Private bodies and cooperative (banks, lawyers, F-Analysts) took years of disagreement. o Professional lawyer standards or doctor standards GAAP is not public law since everyone understands it, its important one and SEC requires that public companies keep their books in accordance with GAP and also requires that public companies are independently and periodically audited in accordance with Genarally Accepted Auditing Standards. o What you dont want to see when you get audited: Concerns about viability of company Just because you violate GAAP doesnt mean anything. If you do cash accounting with a shoebox doesnt mean you will get arrested. Its the public companies that need to comply with GAAP and those that get in trouble are the ones that say they comply but dont.

No common law cause of action for not following GAAP but there is a common law violation for fraud. FS paint a fairly objective picture thus far but ratios dig further since FS shows what needs to be assessed further. o Ratios help make comparative judgments on how the company has done, or how it has compared to other companies. Ratios between different elements of a firms financial statements. o APEX FINANCIALS PROBLEM 12 Liquidity (do we have enough in our current assets to meet these debts that will come due quickly) Current Ratio = Current Assets (short term) / Current Liabilities (short term) = While you might think that a high ratio is good, having too high a ratio means you are hoarding cash and not paying off liabilities. Also want to ask what kind of assets we are talking about while there is a good current ration not a lot of it is in cash. Solvency Ratio Looks at firm as a whole and measuring whether it has an ability to meet its debt as a going concern. Are we run in such a way that we wont sink for not meeting our debts year after year. 1) Leverage how much of your operations funds with debt higher leverage o 1 way to measure is debt to equity ratio (liability over surplus) (terms are intertangeable) for every dollar that you are funding for your business, you are funding it with 69 cents of debt. 2) measures interest coverage compares the annual interest expense to the earnings; this shows us how much earnings well have to make to finance our debt. o Operating Earnings / Interest Expense Managerial Efficiency Ratios How efficieintly is the company being run Accounts receivable/sales ratio = how long its taking company to collect on its debts. o If the % is 9.6% then thats telling us that for every dollar theyve sold, they have about 9.6 cents that they havent collected on. o We add 1,5000,000 + 2,250,000 to arrive at 3800000/13400000 for 2001 Turnover Ratio: ratio of cost of goods sold to year end inventory (means that they filled their warehouse up four times. If their ratio is 100 then they filled their warehouse back up 100 times. The number of times they have to fill their warehouse up so in this case, they replenished their inventory about 4 times. The more times you replenish the inventor, the more efficient you are being because it costs mone to have inventory sitting around. o Year 2000: 6.67 mil/1.69 mil = 4% o Year 2001: 8.15 Mil / 250000 = 32.6% (wow they became wildely more efficient from 2000 to 2001) (they could have also cut down inventory and it was easier to replenish with less inventory) (they could have also advertised more) Interest Cost Ratio (measures how much they are paying to borrow by measuring how much they are paying to borrow over how much they are actually borrowing) o Interest expense / Notes Payable (short term and long term) o Year 2000: 103,000 / 1375,000 = 7.5 cents for every dollar they borrow is how much it is costing them to borrow.

o Year 2001: 210000/1275000 = 16% so now its 16 cents on every dollar. Why are creditors charging this company double interest. What happened? Did they get new loans since the new loan is long term. Profitability Ratio Margin how much you are selling it for minus your expenses o Operating earnings / revenue o 2000: 1300000 / 10400000 = 12.5% (margin is your making 12.5 cents on the dollar after expenses) o 2001: 1370000 / 13400000 = 10.2% (making less money than in 2000) you have a higher sales revenue but also higher expenses and this is why this happens ROA how much income you are bringing in for the assets that you have (net income / total assets) o 2000: 718200/5615807 = 12.79% (how much of your assets youve produced in the form of income) you are making 12.7 cents for every dollar of assets you have o 2001: 1020000/5697700 = 17.9% = return on assets went up a bit. Extraordinary gains is this really an accurate measure of our assets. ROE how much are we making for every dollar we have invested in the business o 2000 - 21.6 making 21 cents for every dollar invested in the company o 2001 - 31.56% so 31.56 cents for every dollar invested in the company. Earnings per share and Price earnings ratios: Net income / outstanding shares 7182000 / 200000 = 3.6% = $3.60 company made per share. Company could have put all of that money back into company for expenses etc. that is just what earnings per share were. How to measure the price of a stock based on this if earnings per share was paid out as a dividend meaning you will get 3.60 in your hands per share at the end of this year. What will happen next year is unclear but if you have this info from years past, you can figure out a better idea of what the historical cost per share is. Maybe this is an annuity. What is the present value of this annuity at a 10% interest rate. Maybe market value of that share is 36 dollars. This is one way to bring the two elements of the course together Whats the market value of the company, what should we pay for it if it doesnt have any established market value so far. If you are looking for condos and you want the market value look at the comps in the neighborhood to come up with the price per square foot. Do the same with companies. Eskimo Pie look at ratios for market value o 1) Book Value of the Equity in 1990 was 19.5 Mil (people who have invested is what that shows) there are other companies similar to this company and whose book value is alike and we can also get their market value because they are publically traded (i.e., ben and jerrys) so what is the ratio of market value of equity over the book value for each of these companies. Get the average of all of these companies and this is the market value. o 2) Ratio of income o there is a connection between the time value of money and what you can draw out of these ratios.