Accounting for Lawyers Exam Outline

First Principals

Three Pillars: Chapter 1 Introduction to GAAP Components of Financial Statements Introduction to GAAS Finance and Using Financial Information

AccountingThe Fundamental Equation: Chapter 2

Assets, Liabilities and Equity Journal Entries Creating the Balance Sheet Revenues and Expenses Creating the Income Statement Nine Possible Pairs Data Management

The Accrual System and Recognition Principles: Chapter 3 Cash v. Accrual Accounting Revenue and Expense Recognition Four Timing Matters Adjusting Entries Conversion Exercise

Inventory and Cost of Goods Sold: Chapter 4 Recording the Cost of Goods Sold Determining the Cost of Goods Sold Lower of Cost or Market Cost Accounting Disclosure and Tax Matters

Fixed Assets and Depreciation: Chapter 5, pages 92-102, 107-09 Relationship to Other Concepts Required Judgments Depreciation Bookkeeping Tax Depreciation Distinguished

Other Asset and Liability Issues: Chapter 6, pages 114-35, 138-47 Receivables Intercompany Ownership Financial Instruments Intangible Assets Employee Matters Loss Contingencies

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Capital Accounts: Chapter 7

Contributed Capital and Distributions Retained Earnings and Dividend Bookkeeping Other Comprehensive Income Hybrid Instruments Non-Corporate Entities

Financial Statement Analysis: Chapter 8 Liquidity and Activity Profitability and Performance Management’s Discussion and Analysis (MD & A) Critical Accounting Policies Segment Reporting Ratio Categories

Statement of Cash Flows: Chapter 9 Rationale and Organization Direct Method Indirect Method Assessment Analyzing Cash Flow Interpreting Cash Flow Cash Flow Variability

FinanceValuation Principles: Chapter 10

Time Value of Money Future Value Present Value Rule of 72s Interest Rates, Tax Effects and Inflation

Valuation Techniques: Chapter 11 Introductory Parable Balance Sheet Based Valuation Income Statement Based Valuation Cash Flow Based Valuation Synthesis

Finance Theory: Chapter 12, p. 295-311 Introductory Stats Modern Portfolio Theory Capital Asset Pricing Model

AuditingChapter 14

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Reasonable Assurance Internal Control Substantive Tests Concluding an Audit

Shenanigans: Chapter 17 Testing the Line Crossing the Line Audit Failure Satire

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First Principals

Three Pillars: Chapter 1 Introduction to GAAP Components of Financial Statements Introduction to GAAS Finance and Using Financial Information

Introduction to GAAP GAAP: Generally Accepted Accounting Principles – refers to the broad guidelines, procedures,

conventions and rules of accountings Sources: (1) Authoritative Bodies and (2) Conventions Adopted Over Time Pronouncements of Authoritative Bodies: Key is the American Institute of Certified Public

Accountants (AICPA) and the Financial Accounting Standards Board (FASB); the Governmental Accounting Standards Board (GASB) and SEC as well.

General Acceptance Over Time: Widespread Acceptance over time usually from institutions and industries

o Differences in opinions over rules and application of the rules cause uncertainty over accepted standards

Primary Qualities of Accounting Information: Relevance and Reliabilityo Relevance: Accounting info is capable of making a difference to the users of the info –

must be timely and provide info before it loses its capacity influence decisions – (1) make predictions on future events and (2) assess current conditions) or has (3) feedback value to evaluate past decisions

o Reliability: Three qualities – (1) neutrality, (2) verifiability and (3) validity Secondary Qualities of Accounting Information:

o Comparability: Enable users to compare the economic traits of one company to another o Consistency: Accountants used the same procedures from one period to the next rather

than from one company to the next

The Standard for Accountants PCAOB: FASB originally made all the rules, but was replaced by the Sarbane Oxley Act of 2002,

and now they’re replaced by Public Accounting Oversight Board (PCAOB)o FASB was being run/funded by accounting firms involved in cooking the books so SOX

created this independent oversight board (PCAOB).o PCAOB is funded by the company issuing the stock, but the committee is comprised of

independent disinterested members. SEC are the enforcers for all financial institutions.

o They oversee all the financial statements the companies disclose.o SEC reviews financial statements, investigate them, and try them.o Securities Act of 1993 – regulates NEW issue of stocko Securities and Exchange Act of 1934 – regulates disclosure once these shares are

publically traded.o These Acts prohibit MATERIAL misrepresentation or omission in documents that are

prepared for the public.

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Note: this applies to inside counsel, you should know what your accountants are doing.

American Institute of CPAs (AICPA)o This is like the ABA for lawyers, it’s an advocacy group that promotes uniform licensing

(deciding how you can become a CPA and enforces CPA conduct). GAAP (Generally Accepted Accounting Principles)

o These principles MUST be followed by anyone who prepares financial statements (rules and conventions accountings/management have to obey by when preparing statements).

o Provides standards of practice and standard of professional conduct of CPAs.

Environmental Assumptions Defined: Accounts make several assumptions concerning the financial environment Periodic Reporting Assumption: Report info in discrete periods of time – daily, yearly, etc. Unit of Measurement Assumption: Report info in terms of its value US Currency Going Concern Assumption: Assume that unless there is reason to believe that a business will

be liquidated that it will continue indefinitely into the future Separate Entity Assumption: assume that each economic entity is separate and distinct unit

o Consolidated Companies: accountants consolidate financial statements of different corporations when the corporations are part of a single economic entity

Conservatism Assumption: Conservative basis to state informationo Rationale: assumption that investors and lenders who use financial statements should

not be misled about vitality of the entity o Example – companies traditionally expense the costs of organizing a business as quickly

as possible rather than recording the costs of on the balance sheet as an asset Implementation Principles: Cost Principles and Realization Principles

o Cost Principle: Initially record assets at their initial cost (e.g. company makes purchase cost reflects the true value of asset; cash – record asset received as the amount of money paid for it and noncash – record the asset acquired by the value of either the asset given up or asset acquired)

Example – ABC buys van for $24,000 – accountant records van at its $24,000 cost

Trades van for used jeep – record cost of jeep as either value of jeep or value of van – whichever is more easily ascertainable

o Realization Principle: Specific criteria as guide when deciding when to record revenue Reasonable Assurance of Collect: do not record revenue until reasonably

assured of collecting on sale Substantial Completion: do not record until seller has performed most of its

obligations o Matching Principle: Record expenses at same time as they record the revenues the

expenses helped produce Record from a sale revenues, also record the expenses that were made in

completing the sale Example – ABS sells inventory item for $10, records expenses related to the

same (e.g. costs of making the item) at same time

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Definitions of Accounting Terms Accounting Entity: Either the unit for which the accounting is done (e.g. partnership or

corporation) Economic Events: Financial events or transactions the accountant reports in monetary terms

(e.g. sale) Assets: Resources that have probable future economic benefits; assets must:

o (1) Have probable future economic benefitso (2) Be under the control of the company

(3) Are the result of past transactions (and not just anticipated)

Liabilities: Probable future sacrifices of economic benefits; creditors’ claims against the company; to be classified:

o (1) Requires the company to transfer an asseto (2) Known to whom the asset must be transferred ando (3) The result of past transactions

Equity: Residual interest in the assets of a business minus the liabilities consisting of business owner’s interest in the company

o Sometimes called stockholder’s equity, net assets, net worth or net book valueo Value of Assets – liabilities = equity o Value of assets in financial statements is based on original cost and not their current

value – so equity is portrayed in financial statements is not at all necessarily the fair market value of the business because of the distortions

Revenues: inflows of assets or reductions of liabilities during a particular accounting period if they arise in the ordinary course of business

o Example – fees earned by a law firm BUT not sales of desks at the law firm o Arise from: (1) primary earnings activity of the company and not from incidental or

unrelated investment transactions and are (2) recurring and continuous Expenses: Outflows of assets or creations of liabilities in the ordinary course of business (e.g.

salary law firm pays an associate) Gains: Increases in equity from peripheral or incidental transactions – do not result from the

operations of business (e.g. law firm selling desk) Losses: decreases of equity from peripheral transactions Capital Contributions and Distributions:

o Contributions: Increases in equity from asset contributions or liability reductions by the owners of a company (e.g. if an investor buys stock of ABC from company itself)

o Distributions: opposite – decreases in equity (e.g. law firm distributing its profits to its partners and a corporation paying dividends to shareholders)

Account: Place where accountant store economic data – similar to checking accounts o Used for all categories of assets, liabilities, equity, revenues, expenses, gains and losseso Example – corporation stores aggregate amount of cash its own in its cash account and

total dollar value of machinery it owns in machinery account Debit and Credit:

o Debit: entries to the left side of the ledger – increases asset, expense and loss accounts AND decreases liability, equity, revenue and gain accounts

o Credit: entries to ride side of ledger - decreases asset, expense and loss accounts AND increases liability, equity, revenue and gain accounts

3 Requirements for Asset1. Control2. Future benefit3. Transaction for Measurement

3 Characteristics of Liabilities1. Involve a present duty2. Obligates the entity3. Transaction for Measurement

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Basic Accounting Equation: Theory: An asset is always claimed by either the corporation’s owners or the creditors of the

corporationo Example – corporation has $300,000 assets and liabilities of $240,000 – has owner’s

equity of $60,000 so if it dissolved, the first $240,000 would go to the creditors and the remainder would belong to the owners of the corp.

Double Entry Accounting: based on premise that accountants must record every transaction that occurs with at least two components so that assets minus liabilities always equal equity and debit always equals credit (debit one, credit another)

Accounting Period: Time on which the accountant reports – usually one year Financial Statements: information reported – standardized by AICPA

o Balance Sheet: listing all asset, liability and equity accounts of a business on a particular date

o Income Statement: financial statement showing company’s income (revenues, expenses, gains and losses) for the counting period – reports amount of activities achieved over a discrete period of time

o Statement of Cash Flows: shows companies inflows and outflows of cash during period o Statement of Retained Earnings: details changes in company’s retained earnings account

during accounting period

Auditing Overview All publically traded companies have to be audited by one of the big 4 firms. Auditors MUST be independent – must NOT have ties to that particular company & must be a

member of one of the big 4. Financial Statements are prepared by the Management .

o Includes: Balance Sheet, Statement of Cash Flow, Statement of Shareholder’s Equity, and Statement of Income.

o Auditors come in and review the financial statement then issue an Opinion of the statement.

o If auditors did NOT get all 4 of the statements above, then they CANNNOT issue an Opinion.

Fiscal year ends anytime other than December 31st

Standard of Review:o Audit report will say they conducted their audit “in accordance with the standards of the

Public Company Accounting Oversight Board (PCAOB)”o PCAOB asks auditors to provide REASONABLE assurance that report is free from

MATERIAL misstatements. Note: auditors do NOT guarantee accuracy of financial statements nor do they

detect fraud, they’re there to make sure accounting principles are followed (accuracy of statements only).

ASSETS = Liabilities + Owner’s Equity OR

Assets – Liability = Owner’s Equity

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Date Account Ref. Debit Credit

1/1/10 Note Payable: Stanley 100.00

Cash 100.00

(To record payment of the note)

Auditors examine on a Test Basis:o They can’t look at every transaction, so to be cost effective, they look at sample tests.o Companies want their statements to be as accurate as possible, so when auditors come

in things don’t look funny and auditors will NOT have to expand test samples (larger test samples = higher costs for the company).

Footnotes – again, used to disclose thingso IE: company is doing business with _____, possible litigation, etc.

Audit requires companies to make Estimates:o IE: company give warranties, but it is difficult to calculate how much that warranty

payment will cost.o Auditors scrutinize these estimates b/c this is another place where companies can play

with the numbers. Auditors can look at estimates for last year and see how close they were.

o PROF: this and accounts receivables are popular places to hide $ Financial Statements are ALWAYS shown over several years

o This is so investors can look at trends in the company (say over 2yrs), so you can compare between yrs.

Rule: ALL audits MUST conform with the Generally Accepted Accounting Principles (GAAP).o Some financial statements will include an additional paragraph saying the company has

done something and put you on notice such as adopting/changing their accounting method.

As of 2002 (SOX), all audits reports will have auditor’s Opinion of the company’s Internal Control.

o Auditors will state the quality of the internal control over financial reporting.o All publically traded companies want to get an UNQUALIFIED opinion/report.

Qualified opinion/report BAD! (company’s stock will plunge)

Introduction to GAAS Auditing: Techniques of examining and reporting on the accounting records and underlying data

of a company SAS: Statements of Auditing Standards issued by AICPA are benchmarks Preliminary Survey on Entity: When company hires auditing firm, one partner makes survey to

do extensive review of industry and company, financial statements and ratios and trends Assurance of Independence of Auditor: SEC requires some companies to include opinion letters

with their financial statements these must be issues by independent auditors o SEC independence: Rule 2-01(b) of Regulation S-X

Audit Program: auditor develops an audit program – list of things to do during audito Verify financial statements and underlying data are correct with test on accountso Assesses internal control procedures of the companyo Validate legitimacy of transactions by seeking third party confirmations

Implementation: after plan, test various accounts and records work on working paperso Example – working paper showing a reconciliation between cash account and the

amount of cash per the bank statement The Report: At the completion, issues report stating that exam was conducted in accordance

with GAAS (generally accepted auditing standards) and whether the statements are presented in accordance with GAAP, as well

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The Auditing Report Function: to express informed opinion on financial statements based on exam and own

judgment Types: (1) an opinion or short-form report and (2) opinion plus additional comments and data or

long-form report Parts to Report: (1) Date, (2) Salutation, (3) identification of statements examined and (4) scope

of examination (made with GAAS) Auditing Standards: AICPA publishes three classifications of standards

o (1) General Standards: include adequate training and proficiency of auditor, independence and exercise of professional care and conduct of work

o (2) Standards of Field Work: Require that each work is (1) planned and supervised, (2) performed as study of internal control of company and (3) gathered sufficient evidentiary matter to support a reasonable basis for an opinion

Reporting Standards: Fouro (1) Report must state is GAAP was followedo (2) Must state if principles are consistently applied in past accounting periodso (3) Informative disclosures of financial statements are to be taken as reasonably

adequate unless otherwise stated in reporto (4) Must contain express regarding statements taken as a whole or assertion that an

opinion cannot be rendered and reasons why Types of Opinions:

o Unqualified Opinion: must be able to state that the FSs have been prepared in accordance with GAAP and the principle of consistency has been adhered to –

Used if no restrictions on auditor’s exam and no material deficiencies in FSso Subject to Opinion: If cannot render an unqualified opinion due to the fact that the

outcome of some material unresolved matter is dependent on future developments outside management’s control (e.g. pending lawsuit for account receivable)

o Except for opinion: qualified opinion saying not in agreement with one or more of the accounting principles used or the scope was too limited

Used only if deficiencies in principles or audit was material enough to require mentioning but not of such magnitude to require a disclaimer or adverse opinion

o Disclaimer of Opinion: issued when has great uncertainty about FSs, scope was severely limited or company’s records are so inadequate that cannot render an opinion on the fairness of the statement

o Adverse Opinion: FSs do not present fairly the position of the company – must be convinced did not follow GAAP or company was inconsistent in treated specific items

Unaudited Financial Statements: When accountants take part in preparing FSs, and each page of the statement is marked unaudited and accompanied by a disclaimer from outside CPA

AccountingThe Fundamental Equation: Chapter 2

Journal Entries Creating the Balance Sheet Revenues and Expenses Creating the Income Statement

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Nine Possible Pairs Data Management

Journal Entries Transaction Occurs: First step in the sequence is that a financial transaction occurs –

o e.g ABC sells common stock to Ron Lyda for $50,000 in cash Journal Entry: Next step – note of every financial transaction

o Accountant determines which accounts are affected by the purchase or transaction and place the information in correct account

Process:o (1) Enter transactions chronologicallyo (2) Enter the day before each transactiono (3) Enter debits before credits and o (4) Enter an explanation after each transaction

Financial Statements

Overview and Definitions Balance Sheet

o All resources (assets) owned and amount owed (liabilities) are listed in order of liquidity.o The difference between assets and liabilities represents the stockholder’s equity in the

business.o Typically calculated at end of year (fiscal or calendar), or quarterly

Income Statement o Revenues earned from sales and expenses incurred to produce those revenues.o Usually follows revenues for 12 months.

Statement of Owner’s Equity/Retained Earnings o Contribution of capital + accumulated net earnings – dividends paid to owners =

reinvestment into the bizo Basically tracks contribution of capital, accumulated earnings, and dividend paid out.

Statement of Cashflow o Lists all sources and uses of Cash.o 3 Parts:

(1) Cash flows from operations (2) Cash flows from investments (3) cash flows from financing

o This is VERY important to creditors/lenders. Footnotes

o Used for unquantifiable items that may affect the company (threat of lawsuit, etc).

Management Uses of Financial Statements Managers use FSs as a measure of company’s performance (often bonuses based on

performance)o Basically looked for it for guidance in making decisions.

Marketing and Credit managers use customer’s financial statement to decide whether to extend credit.

Debit CreditCash 50,000Common Stock 50,000

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Purchasing managers use supplier’s FSs to decide whether suppliers have the resources to meet the demand for products.

Employees’ union and human resources managers use FSs as a basis for contract negotiation (pay rates).

Balance Sheet Reflects financial CONDITION of a company at a particular time (usually last day of calendar or

fiscal year)o A snap shot of that date ONLY

Continuity of the Numbers - at beginning of the next year, the previous ending balance on that balance sheet will become your Beginning Balance.

Assets = Liabilities + Owner’s Equity Assets

o Current Assets Cash, securities, A/R, Inventory pre-paid expenses

(can be converted into cash w/in 12 months) Scrutinize the A/R

o Other Assets Usually intangibles (patents, copyrights, etc.)

o Fixed Assets Property, plant & equipment, etc. Always booked at Historical Cost less Accumulated

Depreciation net fixed assets also called “Book Value.”

Goldmine! B/c booked @ historical cost, the FMV today is probably higher! Get an appraisal.

Types of Assets Accumulated Depreciation: Contra Asset account – displayed as an offset to asset accounts, as

opposed to being separately stated as accounts themselves o Income statement account related to accumulated depreciation o To record depreciation taken on fixed asset accounts

Market Securities: Equity and Debt securities

Liabilities Current Liabilities

o A/P (accounts that must be paid in next 12 months), accrued expenses (salaries, expenses), current portion of a long term debt (interest that has to be paid in next 12 months), taxes payable (typically payroll taxes, withholdings)

o 2% 10 met 30 – means if invoice is due in 30 days, you get 2% discount if paid within 10 days.

Long Term Liabilitieso Any debt longer than 12 months (stuff you don’t have to pay

until the future)

Assets: Cash Marketable Securities:

Stocks and securities Notes Receivable Accounts Receivable Inventory Property, plant and

equipment Accumulated

depreciation

Liabilities Accounts Payable Other Liabilities

Payable Dividends Payable Notes payable Bonds Payable

Equity Accounts Common Stock: stock

issued (usually at par value or stated value)

Additional Paid-in Capital

Treasury Stock Retained Earnings

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Owner’s Equity Contributed Capital

o Money paid into the company by owner (capital investment) in exchange for stock.o Remember: contribution capital is NEVER included into revenue (always contributed

capital!) IE: an owner can give a bona fide loan to the company, so if biz fails and

contribution capital is gone, owner can take a deduction for this loan as a loss of biz debt.

o IRS & CA are strict about payroll – must have enough to make payroll + pay taxes. Retained Earnings

o Includes ALL the net income from year to year (at the end of the balance sheet, all added up)

Formula:o Beginning Retained Earnings + Net Income – Dividends Paid = Ending Retained

Earnings Balance Sheet Example:

Assets ($27K) must = Liabilities ($16K) + Owner’s Equity ($11K)o Must add up to the penny

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These are examples of assets, liabilities, and OEo Prepaid Expenses – insurance payments for the year, some biz prepay rent (b/c it’s

prepaid, it’s an asset) Working Capital = Current Assets – Current Liabilities

o Working capital is the $ managers use to buy materials to make widgets, which then becomes inventory, and you turn around and sell the inventory for Cash.

A = L + OE o Debit Side Credit Side

DR CR DR CR + - - +

o Asset – Debit Side If you have an increase in assets, you will have a decrease in credit. If you have a decrease in assets, you will decrease your credit.

o Liabilities + OE – Credit Side If you have increase in liabilities or OE, it will be a credit. But if you have a decrease in liabilities or OE, then it will be a debit.

Double Entry Bookkeeping o DR Equipment (A+) – 100

CR Cash (A-) – 100 Debits affect the LEFT side of the journal. Credit affects the RIGHT side of the journal.

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Examples of Pg 36:1. Larry contributes $10K cash to open new law office.

This will be an increase of $10K in Assets (left side). Also an increase on right side for Owner’s Equity for $10K.

Assets $10K = L + OE ($10K); this OE can be stock, partnership interest, etc Written as:

Cash $10KOE $10K

2. Firm buys stationary for $500 Assets decrease by $500 cash and increase assets by $500. Written as:

DR Office Supply $500 (A +)Cash $500 (A -)

3. Firm buys furniture for $3K on credit card Assets increase by $3K and increase liabilities by $3K

Furniture $3KA/P $3K

4. Firm pays bill from store for $250 Decreased assets by $250 in cash, decreased liabilities by $250 in A/P

A/P $250 (debit side)Cash $250 (credit side)

5. Larry takes sofa home. Decreased assets by cost of sofa (assume $800) and decreases OE by $800 (cuz Larry is getting

something)DR OE $800CR Furniture $800

6. Department store terminates all credit card accounts and calls in all debts Decreased liabilities by outstanding balance $2750 and increases liabilities by $2750.

DR A/P $2750 (L -)CR Notes Payable $2750 (L +)

7. Firm sued for malpractice and settles for $500 Increased liabilities by $500 and decreased OE by $500 (lawsuits often affect OE)

DR OE $500 (OE -)CR Lawsuit Obligation $500 (L+)

8. Lawsuit is dropped Decreased liabilities by $500 and increased OE by $500 Basically reverses #7

T-Account (journal entries in the ledger by account type) Each journal entry will be reported in an appropriate ledge T-

Account. Each type of account is totaled and then reported on the Balance

Sheet.

Problem 2A (pg 40)

T Account

Debits Credits

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Jack & Jill formed J&J Corp, operating bike repair shop, biz began 7/1 and the following transactions occurred in July. Prepare journal entries, T-Accounts, and balance sheet as of 7/31 for J&J:

1. (a) Jack pays $5K to J&J in exchange for stock. (b) Jill transfers land to J&J, $5K value for stock.(a) Cash (A +) $5000 OE (OE +) $5000(b) Land (A +) $5000

OE (OE +) $50002. J&J buys tools/supplies for $1200 charging purchase to its account.

A/P (L +) $1200Note: tent would be on balance sheet, but little supplies (pens) could be written off as an exp.

3. J&J orders $5K in equipment, terms allow order to be cancelled until time of delivery (next spring)NO entry NO accounting b/c they can still cancel the order

4. J&J borrows $6K from bank, 1yr note @ 10% interest.Money (A +) $6KNote Payable (L+) $6K

5. Equipment delivered and J&J pays for it.Equipment (A +) $5000OE (OE -) $5000

6. J& pays ABC $400 on its account.DR A/P (L -) $400CR Cash (A -) $400

7. J&J sells one of its repair stands for $500, what J&J paid for it, Sam gives J&J a note payable in 30 days.

A/R (A +) $500Stand (A -) $500

Assets Liabilities

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Owner’s Equity

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CashDR(1) $5000(4) $6000

CR(5) $5000(6) $400

Calculation: $11K - $5400 = $6000 Cash

Accounts PayableDR(6) $400

CR(2) $1200

Total: $800Notes Payable

DR CR(4) $6000

Total: $6000

Accounts ReceivableDR(7) $500

CR

Total: $500 A/R

SuppliesDR(7) $1200

CR

Total: $1200

EquipmentDR(5) $5000

CR(7) $500

Total: $4500

LandDR(1) $5000

CR

Total: $5000

Owner’s EquityDR CR

(4) $5000(1) $5000

Total: $10,000

Balance SheetUsing the journal entries from the T-Accounts, we can prepare a balance sheet (snap shot) as of 7/31

Assets o Current Assets

Cash - $5600 A/R - $500 Tools/Supplies - $1200

o Fixed Assets Equipment - $4500 Land - $5000

o Total Assets = $16,800 Liabilities

A/P - $800 N/P - $6000 Total Liabilities = $6,800

OE o Total OE = $10,000

Does it all add up?o A = L + OEo $16,800 = $6,800 + $10,000 YES!!! It adds up

Asset Accounts Assets: probable future benefits

o Debit account – debits increase the account and credits decrease it 4 Asset Classifications (listed by declining liquidity)

o Current Assets Cash Marketable securities Prepaid Expenses Current portion of LT assets

o Long-Term Investments

Assets that cannot be converted to cash within one year

o Fixed Assets

Tangible resources such as plant, building, equipment, and land

o Intangible Assets

Lack physical substance and include patents, copyrights, and trademarks acquired for extended use in business

Liability Accounts Liabilities: obligations to make payments or provide services in the future

o Credit Accounts – increase liabilities, debits decrease them Equity Accounts: Residual interest that the owners of the company have in assets (assets –

liabilities)o Credit Accounts – increased by credits and decreased by debits o Example: Assets you own (car, stereo, etc.) if you sold them all and offset your liabilities

(debt, loans, etc.), the amount left would be your equity

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Current Liabilitieso Obligations due with one yearo Examples: accounts payable, salaries payable, accrued expenses

Long-Term Liabilities

o Obligation due in over one year

o Examples: notes payable, leases, bonds payable

Statement of Owner’s Equity Represents owner’s or shareholder’s interest in the company. Reflects contribution of capital by shareholders. Tracks net earnings of the company (from day 1) Accounts for distribution of dividends to shareholders. OE = Assets – Liabilities Sources of OE:

o (1) Contributed Capital Common stock at par value Capital in excess of par value

o (2) Retained Earnings

Statement of Retained Earnings Beginning Retained Earnings + Net Income/loss – Dividends paid to shareholders = Ending

Retained Earnings So there is a beginning balance each year and you add all these things up. Tracks OE from day 1

of biz till end of biz.

Income Statement Income statements give a snap shot of the company at its ending date (numbers will be from the

birth of the company) Reflects financial performance of the company for a period UP to 12 months MAX

o Books are closed and zeroed out at end of 12 monthso Net income/loss is reported on balance sheet in OE section in the retained earnings.

It reports revenue earned from sales to customers along with expenses incurred to produce those revenues.

Income Statement Accounts: Revenues

o Sales revenueo Fee revenueo Interest revenueo Rent revenue

Expenseso Cost of goods soldo Wages expenseo Rent expense

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o Interest expenseo Depreciation expenseo Advertising expenseo Insurance expenseo Repair expenseo Income tax expenses

Income StatementRevenues

$ 15,500

Statement of Retained Earnings

Expenses

(8,500)

Beginning retained earnings

$ 59,000

Net income

$7,000

Net income

7,000

Dividends (2,500)

Ending retained earnings

$ 63,500

Relationships Among the Statements (1) Net income from the income statement results in an increase in ending retained earnings on

the statement of retained earnings.

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(2) Ending retained earnings (from statement of retained earnings) is one of the 2 components of stockholders’ equity on the balance sheet.

Users of Financial Statements External Decision Makers:

o Investors – look for stock appreciation and/or dividendso Creditors – looking for creditworthiness of the company, whether they will be able to

pay interest and repay the principal. Internal Decision Makers:

o Managers – look to see if projecting are followed

Elements on the Income Statement

Revenueso Increasing in assets or decreasing of liabilities from ongoing operations.o Direct impact on OE.

Expenseso Decreasing assets or increases in liabilities from ongoing operations.o Direct impact on OE.

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Statement of Retained Earnings Balance SheetBeginning retained earnings $ 59,000 Cash $ 14,000Net income 7,000 Other assets 171,500Dividends (2,500) Total assets $ 185,500Ending retained earnings $ 63,500 Liabilities $ 42,000

Stockholders' Equity Common stock 80,000 Retained earnings 63,500Total liabilities and equity $ 185,500

Operating Activities

Operating Activities

Peripheral Activities

Operating Expenses

Cost of Sales(used inventory)

Salaries and benefits toEmployees

Other costs (like advertising, insuranceand depreciation)

Earnings Per Share

Basic Earnings per share vs. Diluted Earnings per share:o Basic Earnings Per Share

Will always be HIGHER than diluted earnings per share (doesn’t account for everything, such as stock options)

o Diluted Earnings Per Share

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Worst case scenario, if all convertible stock were converted and all stock option exercised (b/c these things dilute the earnings per share).

Accounting Methods:o Cash Basis Accounting – revenue recorded when cash received, expenses recorded

when cash paid. CANNOT be used with publically traded companies. Very straightforward, book things when cash comes in or out.

o Accrual Accounting – assets, liabilities, revenues and expenses recognized when the transaction has accrued, NOT necessarily when cash is paid or received.

Good for professionals. If you send bill to client and client doesn’t pay, you can book the income, but then you can get a deduction for bad debt.

If you were on cash basis, then you CANNOT book this income, so if your client ultimately doesn’t pay, then you CANNOT get a deduction.

o Revenue Principal – company recognizes revenues when: Delivery has occurred or service rendered There is persuasive evidence of an arrangement for customer payment Price is fixed or determinable Collection is reasonably assured

Income Statement Accounts

Revenue Ledger Accounts Where records revenues – increases in assets or decreases in liabilities from operations Start at zero for every new accounting period When to recognize revenue:

o Product – upon deliveryo Service – when service is substantially complete

Difference from balance sheet ledger accounts: permanent and running total – first entry is always ending account balance from last period

Sales: Account with cash and credit sales in ordinary course of operations Other Revenues: Investments, etc.

Expense Ledger Accounts Record expenses – decreases in assets or increases in liabilities Cost of Goods Sold: All expense and revenue accounts – balance transferred to the retained

earnings account Depreciation expense: costs of fixed assets – property, plant and equipment that expired during

the current period o Fixed Assets: have probable economic benefits for more than one period (e.g. a fact or

plant can make products for resule for a number of years)o Example: company buys machine to make component – estimates will produce 1,000 in

life. If company produces 100 during first year, machine cost allocable to the 100 components the company sold has expired and account would record the potion of the machine’s cost associated with the 100

o Matching Concept: costs producing the components, including wear and tear on machine, are matched against revenues produced by selling them

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Gain and Loss Accounts Record increases in income from peripheral or incidental transactions and temporary Start at zero Nature: credit accounts, credit increases them while debits decrease them; loss accounts are

debit Examples: Gain from sale of plant asset and loss from redemption of company bonds

Cash Flow Statements

Focuses on the flow of cash (in and out) of the company show company’s ability to generate cash.

Tells you whether company has enough cash to pay its short term obligations (suppliers) Banks and lenders look at cash flow (sometimes investors too)

o Looks at actual Cash and actual Expenses (not A/Rs, etc)

Organization Operating Activities

o Cash in & out directly related to earnings from normal operations.o Plus receipt of dividends & interest and payment of interest.

Investing Activitieso Cash in & out related to acquisition or sale of equipment, plants, property and

investments in the securities of other companies. Or loans to others. Financing Activities

o Cash in & out related to external sources of financing (borrowing & repaying of loans, issuance of stock, bonds).

o Plus payment of dividends. Direct vs. Indirect Method:

o Direct Method – reports cash effects of each operating activity PROF’s favorite method

o Indirect Method – starts with accrual net income on Income Statement and converts to cash basis.

Most companies use the indirect method (like Costco) It’s almost backwards they adjust expenses that don’t reflect cash Remember Matching Principal (must match revenue with expense)

So if you depreciate equipment over 5yrs, you need to match expected revenues you’ll receive from the machine over those 5yrs.

Relationships Among the Statements The change in cash on the statement of cash flow is added to the beginning

of the year balance in cash to arrive at end of year cash on the balance sheet.

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Financing of the Company Selling Stock

o Sale of common stock to investors/shareholders. Voting rights, gets dividends, and priority behind creditors & preferred stock

holders.o Can be initial public offering (IPO) or secondary offering.

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Statement of Cash Flows Balance SheetCash flows from operating activities

$ 21,000 Cash

$ 14,000

Cash flows from investing activities

(16,000) Other assets

171,500

Cash flows from financing activities

3,500

Total assets

$ 185,500

Increase in cash $ 8,500 Liabilities

$ 42,000

Beginning cash balance

5,500

Stockholders' Equity

Ending cash balance

$ 14,000

Common stock

80,000

Retained earnings

63,500

Total liabilities and equity

$ 185,500

o SHs participate in growth of company and collect dividends (if issued), but during BK they are LAST to collect (not protected).

Borrowingo Debt instruments like Notes or Bonds.o Lenders do NOT participate in the company, they collect interest + get principal back

ONLY. o In BK they get priority.

Hybrido Preferred Stock – SHs receive interest and some appreciation, can be cumulative and

convertible. Note: if preferred SHs do NOT get dividends, then common SHs do NOT either. Usually NO voting rights.

Issuing of Stock Articles of Incorporation will state how many authorized shares are allowed.

o Note: you never want to issue as many authorized shares as you can, leave some in case you want to bring people on later.

Types of Issued Stock:o Authorized Shares

Maximum number of shares of capital stock that can be sold to the public.o Issued Shares

Number of authorized shares that have been sold Treasury Shares – number of issued shares that have been reacquired by the

corporationo Unissued Shares

Authorized shares of stock that have never been sold. Stock Prices:

o Par Value – stock price originally set by Board of Directors. Booked at Historical Cost to protect creditors, today it’s a totally arbitrary

number.o Additional Paid in Capital – anything above par valueo Example:

Cash paid for 100 shares @ $5 $500 Common Shares (100 shares @ par value $1) $100 Additional Paid in Capital (100 shares @ $4) $400

So here, you got 100 shares but only $100 of it is for stock at par value, everything else is additional paid in capital.

Dividends on Common Stock Usually they’re CASH dividends (taxable event, must report to IRS)

o Smaller companies may issue stock instead of paying cash dividends Declaration Date

o BoD declares dividend, record a liability on books.o There must be sufficient retained earnings or cash to pay dividends.o NOT legally required to declare dividends.

Date of Record o ONLY shareholders owning shares on this date will receive dividend. (no entry)

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Date of Payment o Record dividend payment to shareholders in books.o This is when you actually receive a check.

Double Taxation on Corps?o Interest is deductible if corp gives interest (stock), then ONLY the SHs are taxed

personally.o Dividends are NOT deductible so if corp issues dividends, corp is taxed on it and the

SHs are taxed personally as well. Qualified Dividend still taxed on corp, but only taxed 15% for SHs (much lower

rate so tech companies began issuing dividends).

Dividend Yield Ratio This ratio is often used to compare the dividend paying performance of different companies. Formula

Dividends Per Share Dividend Yield = Market Price Per Share

IE: if dividend per share .40 / market price 16.01 = dividend yield of 2.5%o Yield fluctuates constantly b/c of market price, but dividend per share will remain

constant.

Stock Dividends Distribution of additional shares to owners (instead of cash) NO change in total SH equity NO changes in values Pro Rata – NOT taxable event b/c all SH retain the same percentage of ownership. Non-Pro Rata – taxable event b/c SH ownership percentages changes.

o Where some people get cash some get stock, thus some will end up with more stock than before.

Stock Splits Stock splits change the par value per share, but total par value is unchanged. IE: a corp had 3000 shares outstanding @ $2 par value and declared 2:1 split.

Before Split After Split Common Stock Shares 3,000 6,000 increase Par Value per share $2 $1 decrease Total Par Value $6000 $6000 NO change

Basically stock splits provide you with LIQUIDITY, when stock prices go down, more people can buy it, so companies that are doing well will do this to add more shares on the market (adding liquidity), and as a result you will usually see the stock value go up.

Reverse Split – if doing bad, company can do a reverse to boost stock prices (stay away!)

Stock Options Allows employees to purchase stock from corporation at a predetermined, fixed price, as a part

of a compensation package.

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NO deduction for the corporation whereas, when corp pays you a salary, it gets a deduction thus decreasing profits for the company.

o Problem with stock options is that when given, corps are NOT decreasing its profits, so companies are staying away from stock options now.

Preferred Stock Usually fixed dividends, non voting, and preference over common stock. Can be cumulative or convertible. Dividends on Preferred Stock:

o Current Dividend Preference Current preferred dividends MUST be paid before paying dividends to common

stock SHs.o Cumulative Dividend Preference

Any unpaid dividends from previous years (dividends in arrears) MUST be paid before common dividends are paid.

o If preferred stock is Noncumulative, any dividends NOT declared in previous year are LOST permanently.

Bonds You buy bonds to get the interest it pays out (IE: 5%) Sometimes you buy bonds at a premium depending on how much you will be paid.

o So if market is bad and bonds being issued are paying 1%, you might want to sell this one and buy one that pays more but pay a premium for it.

Inventory and Costs of Goods Sold (COGS)

Inventory Merchandising Business – biz engaged in purchasing items for resale. Manufacturing Business – biz engaged in manufacturing of items. Service Businesses – doctors, lawyers, provide service to people Both types of businesses will have INVENTORY.

o For manufactured goods, inventory will include: cost of raw materials, work in progress, and finished goods.

How do you Account for Inventory Product Cost

o Direct Labor + Materials + Overhead (heating, electric bill, etc) Product cost is expensed ONLY when the item is sold (removed from B/S to I/S) Periodic Cost

o Management salary, advertising, heating bill for showroomo Periodic cost is expensed IMMEDIATELY

Cost Accounting Very important to determine price of a manufactured item to stay competitive and profitable. Direct labor + materials + overhead

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Reporting Inventory Items purchased or manufactured are added to Inventory and reported on Balance Sheet @

“cost.” When item is sold, the inventory on the Balance Sheet is reduced by “cost” of item sold. Revenue from sale of items is reported as sales on Income Statement, and at the same time a

deduction is taken on the Income Statement for Cost of Goods Sold (COGS) of item sold.

Valuing Inventory 3 Methods:

o (1) Specific Methodo (2) Cash Flow Method (LIFO, FIFO, Average)o (3) Lower of Cost or Market

Cost of Goods Sold (COGS) Beginning Inventory + Purchases – Ending Inventory =

COGSo Gross Profits = Sales – COGS

Specific Methodo Used for specific, expensive, unique large items (art dealers for cost of acquiring a

Picasso, or Boeing) Cash Flow Method

o Used by many businesses for small items purchased in large qualities.o 3 Methods:

FIFO – first goods purchased in inventory deemed sold first (pipeline) LIFO – last goods purchased in inventory deemed sold first (barrel) Average – average cost of the goods sold

Lower of Cost or Marketo Items booked at cost but if value of inventory goes down, principle of conservatism

requires reduction in value of the inventory to replacement cost.o In other words, if you had to sell your goods in market it will sell for less, thus value of

your asset goes down.

Example of FIFO:

Firm begins the year on January 1 with beginning inventory of 200 books produced at $10 each. During the year the firm produces 200 books on 3 different occasions at an increasing cost. The ending inventory on December 31 is 300 books. Sales $10,000. Firm uses FIFO.

BI 1/1 200 books @$10 $2,000 3/15 200 books @$11 $2,200 6/15 200 books @$12 $2,400 7,200 9/15 200 books @$13 $2,600 EI 12/31 300 books 200@$13=2,600

100@$12=1,200 BI + Production cost – EI = COGS 3,800 EI 2,000 + 7,200 – 3,800 = 5,400 Sales – COGS = Gross Profit

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10,000 – 5,400 = 4,600

Here, the cost of making the book went up (raw material cost or labor cost went up).o BI – beginning inventoryo EI – ending inventory

At EI, they had 300 books left so this means they sold some books (500 books). We need to find out the value of the remaining books and that will vary depending if you use FIFO or LIFO.

o FIFO – first in first out 300 books left. 9/15 you have 200 books and you had 100 books left from 6/15. Remember: reduce inventory by cost (b/c you books at cost, NOT reduce by

sales price) So sales price ($10K) – COGS ($5400) = $4600 gross profit

Now you go to your Balance Sheet and say you sold 500 books @ $10K but it only cost me $5400, thus gross profit of $4600.

Example of LIFO

Firm begins the year on January 1 with beginning inventory of 200 books produced at $10 each. During the year the firm produces 200 books on 3 different occasions at an increasing cost. The ending inventory on December 31 is 300 books. Sales $10,000. Firm uses LIFO.

BI 1/1 200 books @$10 $2,000 3/15 200 books @$11 $2,200 6/15 200 books @$12 $2,400 7,200 9/15 200 books @$13 $2,600 EI 12/31 300 books 200@$10=2,000

100@$11=1,100BI + Production cost – EI = COGS 3,100 EI2,000 + 7,200 – 3,100 = 6,100Sales – COGS = Gross Profit10,000 – 6,100 = 3,900

LIFO – last in first out (think barrel) Here, we have 300 books left, and these would be books from 1/1 and 3/15 batches.

o So again we have $10K sales – COGS ($6100) = Gross Profit $3900 Note: in an inflation environment, your gross profits are HIGHER with FIFO, but once you pick a

system you have to stick with it.

Perpetual Inventory Each transaction is recorded CONTEMPORANEOUSLY (whereas physical inventory is taken at end

of the period to determine spoilage).o Before computers, perpetual inventory was taken at end of each period to determine

COGS. But now, when register rings, it record the transaction and allows the company to monitor its

inventory (H&M, Zara)

Disclosure Company discloses what method they used for inventory accounting in the Footnotes.

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Taxation Taxpayer MUST follow same method of accounting for inventory for tax purposes.

Cash vs. Accrual Method of Accounting Cash Method – income recognized when cash actually received

o Expenses deducted when actually paid.o Used by individuals, small businesses, small corps, or professional corps.

Accrual Methodo Required by GAAP to be used on Financial Statementso Matching Principal – expenses MUST be matched to revenueso Revenues booked when earned whether received or noto Expenses deducted when incurred whether paid or noto Notes:

ALL large public companies HAVE to use Accrual Method Examples:

o Attys prepares a will in Dec but gets paid in Jan, when is income reports? Cash – Jan Accrual – Dec

o Atty purchases computer in Dec but doesn’t pay till Jan, when is deduction taken? Cash – Jan Accrual – Dec

DepreciationOverview:

Assets with expected life over 1yr are depreciated. Fixed assets generating revenue over a period of time can be depreciated. Matching Principal – better to match expenses with revenues Land is NEVER depreciated (only buildings)

Example: Company purchases equipment for $5,100,000. Salvage Value is $100K. Useful life is 5yrs.

$5,100,000 - $100K = $5mil (depreciate basis) Straight Line Method

o Yr 1 Yr 2 Yr 3 Yr 4 Yr 5o 1mil 1mil 1mil 1mil 1mil

Salvage Value – what asset will sell for at end of its useful life (used to determine tax deductions)

1st 3yrs are the Accumulated depreciation, which reduces the cost of the equipment on the Balance Sheet.

Year 4 is the current year depreciation (on the income statement)

Types of Depreciation Depreciation – for tangible assets (building) Amortization – intangible assets (licenses, patents, biz goodwill) Depletion – for natural resources like oil or gas

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Elements of Deprecation (1) Cost of the Asset

o Historical cost + Installation + Adaptation expenseo Repairs – expensed right away (major repairs like replacing roof can be added to basis

and depreciated) (2) Salvage Value

o Scrap value for how much you could sell the item for at the end.o Salvage value deducted from above cost giving you DEPRECIABLE BASISo Salvage value is NEVER deducted for tax purposes, ONLY for financial accounting

(3) Expected Useful Lifeo Given by IRS tables – for financial accounting, the LONGER the BETTER depreciation

reduces income. (for tax purposes you want accelerated depreciation to immediate deduction)

(4) Depreciation Methodo Straight Line – used for Financial Statements

B/c you want to show as much profit as possible Residential and Commercial Real Estate is ALWAYS depreciated on the Straight

Line Methodo Declining Balance (accelerated) – used for tax (first few years you get more deduction)

For tax purposes you want to show as little income as possible You can use one method for the FS and one for tax Note: for inventories you have to use the same method, can’t be different.

Depreciations for Tax Purposes S 179 – allows for an expense deduction for items you buy for your business (no need to

depreciate) up to $250K a year can be written off immediately.o Such as computers, fax machines, etc (good for small businesses)o There are limitations for luxury cars.

Rule: MUST hold asset OVER 1yr to take deductiono Asset also MUST be used for business or investment (personal property CANNOT be

depreciated).o So you can’t depreciate your personal home but you can depreciate your investment

home.Problem 4B (pg 87)

1. 19. (a) Service provided of $8400. $1900 charged and rest paid in cash. (b) At end of the month $1600 charges outstanding and $300 was paid. (a) Cash $6500

A/R $1900Revenue/Sales $8400

(b) Cash $300A/R $300

2. 20. Receive $1000 in payment from customer who charged services. Cash $1000 A/R $1000

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3. 21. J&J provided promised services to Bike Club, but club terminated arrangement. NO entry

4. 22. (a) J&J paid salary of $1500 each to Jack & Jill. (b) Incurred obligation to pay additional bonus of $450 and $500 to Jack & Jill. (a) Salary Expense $3000

Cash $3000 (b) Bonus Expense $950

Expenses Payable $950

5. 23. J&J got line of credit with supplier and bought $1300 worth of tubes/tires. Inventory $1300

A/P $1300

6. 24. J&J sold $2500 of tubes/tires. $1800 cash and $700 on credit. (a)

Cash $1800A/R $700

Sales $2500 (b)

COGS $1050 (see below)Inventory $1050

7. 25. As part of a promotion, Verizon waived J&J’s phone bill for Sept. NO entry

8. 26. J&J conduct physical inventory on Sept 30, determined it had tubes/tires that cost $1250.

COGS Calculation: Beginning Inventory – $1000 (include in inventory) Purchases - $1300 Ending Inventory - $1250 BI (1000) + Purchases (1300) – EI (1250) = Total COGS $1050

o Remember: this is an expense and it reduces Owner’s Equity and Inventory

Financial Ratios

Overview: Ratios are compared with ratios of other companies or with industry averages. Ratios may vary because of industry’s characteristics, size, or accounting policies. Financial Statement analysis is based on comparisons with similar companies or within the

company to see trend from year to year. Financial Statement analysis depends on who’s looking at them:

o Investorso Creditors

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o Managers

Investors In considering investment on a stock, investors evaluate company’s payment of dividends and

growth potential on 3 factors:o (1) Economywide Factors

Overall health of the economy has direct impact on performance of an individual business (interest rates, unemployment rates, inflation rate).

o (2) Industrywide Factors Certain events have an impact on just a particular industry.

o (3) Individual Company Factors Analysts look at not only the FS, but they visit the company, buy their products,

talk to people in the company, look at the biz strategy, product differentiation, cost advantage, etc.

Creditors Creditors look at the Cash Flow in the company is there Cash to pay interest & principal?

o Why does the company need $? Does company have any other debts?

Management Looks at liquidity, growth, profitability, efficiency & performance of the company. Managers prepare budgets and see if budgets are met. Also concerned with employee availability and cost. Managers MUST comply with laws and regulations.

Cash Flow Formulas to Know (rest are on Financial Ratios.ppt)

Current Ratio Current AssetsCurrent Ratio = Current Liabilities

Ratio Measures ability of company to pay current debts as they become due. Current Ratio of 2 or less is conservative (optimal level depends on the biz lower the better,

more stable).

Quick Ratio Current Assets – (Inventory + Prepaid Expenses)Quick Ratio =

Current Liabilities

Also called “Acid Test” measures company’s immediately ability to pay debts (like current ratio)

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But this is more Stringent test of short term liquidity; quick assets are cash or near cash assets like short term investments or A/R.

Minimum is 1, less than 1 is better

Inventory Turnover RatioCurrent Year COGS

Inventory Turnover Ratio =Average Inventory

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Inventory Turnover in Days365

365Inventory Turnover in Days =

Inventory Turnover Ratio

Inventory Turnover Ratio

Measures how quickly the company sells its inventory (measures effectiveness of converting inventory into cash).

IE: grocery stores have high inventory turnover b/c of spoilage, but a car dealership will have slower turnover.

Accounts Receivable Turnover Ratio

Net (credit) SalesA/R Turnover Ratio = Average A/R

Average A/R = (Beginning A/R + Ending A/R) / 2

Accounts Receivable Turnover in Days

365A/R Turnover in Days =

A/R Turnover Ratio

Measures how quickly a company collects its accounts receivables (effectiveness of collections, look for aging schedule, shorter the better).

PROF: less than 90 is best

Gross Profit MarginGross Profit

Gross Profit Margin = Total Sales

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Gross Profit = Sales – COGS Compare your profit margin w/other businesses and see if you’re profitable (also can look at

trend from period to period).

Net Profit Margin Net IncomeNet Profit Margin = Net Sales

Indicates how effective management is generating profit on every dollar

Financial Statement Analysis Horizontal Analysis – looking at how company is doing from year to year (comparing items like

assets, etc)o Look for percentages of changes, easier to compare with other companies.o Here, we have a big jump in liabilities and plaint equipment, so that means they spent $

(taking on liabilities) to buy the equipment, so this means they should generate more profit in the future.

Vertical Analysis – where if you’re looking at the total assets, and see what % of current assets represent the total assets (do the same for plant assets, liabilities, etc).

o Just look at the percentages (IE: liabilities represent 58% of shareholder equity)

Valuation Principals

Present Value Decision to take $ now or later longer you wait, less likely to be paid 3 Factors to Consider:

o Utility – can use $ now & invest ito Risk – will $ be there later?o Lost Opportunity

To calculate present value, you use Tables:o Present Value of Lump Sum (pg 246)o Present Value of Annuities (pg 248)

Present Value of Lump Sum Ex: What is the present value of $100 to be received at end of 2yrs (assuming rate 4%)?

Go to table for lump sum look for 2yrs @ 4% $100 x 0.9246 = $92,46

o Why is this $ worth less in the future? B/c of inflation, $ worth less in the future… Ex: You’re settling a case, you either get $1000 now or $1,500 in 5yrs. What do you

choose? Go to table for lump sum look for 5yrs $1500 x 0.8219 = $1,233

o Answer: so you do get more in the 5yr plan but there is a risk…

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Present Value of Annuity Ex: What is present value of annuity paying $5000/yr over 5yr period (assume 5%)?

Go to table for annuity look for 5yrs @ 5% $5000 x 4.329 = $21,645

o Why is this important? B/c insurance company wants to know how much $ they need to collect today to be able to pay this annuity.

o Annuities – a series of payments that can be immediate or in the future.

Future Value of Lump Sum You are saving to buy a car or house and you want to know how much your $ deposited today is

going to be worth in X number of years in the future. Ex: You have $1000 in an investment account pay 4% interest, compounded annually?

Go to table for future value of lump sum (pg 241) look for 8% and 5 payments $1000 x 1.4693 = $1,469

Ex: What if we have compounding semi-annually over 5yrs (8% / 2 = 4%)

$1000 x 1.4802 = $1480o Here, because interest compounds 2x a year (assuming earning 8%/yr), we take 8% and

divide that by 2 because we need to extend the number of payments from 5 to 10 (paying 2x a yr). Then go to the table.

We give them 4% 2x a yr so at end of the yr it still adds up to 8%.o Make sure you reduce the interest rate by the number of payments within the year and

extend the number of payment periods.

Rule of 72 Dividing number 72 by rate of interest gives approximate number of years it will take to

double your $ Ex: You invest $500 @ 9%

o 72/9 = 8yrs for you to have $1000 Ex: X wants to be a millionaire at age 65, he is 25 now, if he can get 9%, how much will he need

to deposit today?o 72/9 = 8yrs (so every 8 yrs his money doubles)

Age 65 $1mil Age 57 $500K Age 29 $250K Age 41 $125K Age 33 $62,500 Age 25 $31,250

Notes on Interest Rates HIGHER interest rates means higher cost for companies to borrow $, but good for retirees b/c

they’re earning $ on their investments.o Usually when interest rates go UP, stock market goes DOWN (b/c company profits drop)o Lower interest rate is better for companies, not good for retirees.

Municipal Bonds – tax free from federal and state (for state it must be bought from the state that you live in)

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Problem 10 (pg 258)1. Rachel has $10K in savings accounting paying 9% interest compounded annually. She’s 65, son is 6.

(a) what will her balance be when son graduates (in 10yrs)? (b) Balance if compounded semi-annually? Go to table for Future Value of Lump Sums (pg 241) 9% @ 10 payments (a) $10K x 2.3674 = $23,674 (b) $10K x 2.4117 = $24,117 (no table for 4.5% just remember interest/2 and double the pay

periods)

2. Laura won price, choice of: $15K cash now or $1800 cash paid annually for 10yrs. Assume Laura would deposit $1800 annual payments in bank account earning 12% compounded annual. (a) What should Laura choose? Go to Table for Present Value of Annuities (pg 248) (a) $1800 x 5.650 = $10,170

o So here, Laura should choose the $15K now.

3. You won lotto, $1mil paid in 20 annual payments of $50K each. NY bond currently pay interest 7%, what is present value of what you won in the lotto? $50K x 10.594 = $529,700

4. What amount of $ do you need to invest on your bday to reach $1mil on our 65th, 8% return. Rule of 72 72/8 = 9yrs

o Age 65 $1mil Age 47 $250K Age 29 $62,500o Age 56 $500K Age 38 $125K Age 20 $31,250

5. What is the max an investor would pay for a $1K 10yr bond that paid $120 interest annually? 8% rate. Use table for Present Value of Annuities (pg 248) $120 x 6.710 = $805.20 Use table for Present Value of Lump Sum (pg 246) $1000 x 0.4632 = $463.20

o $805.20 + 463.20 = $1,268.40 this is the max the investor would pay

6. Investment opportunity paying $400/yr for 1st 10yrs, $600yr for next 15yrs. 8% rate. What is the present value? Use table for Present Value of Annuities (pg 248) $400 x 6.710 = $2,684 $600 x 8.559 = $5,135.40 now we need to discount this as if it was a lump sum at the end of

10yrs.o Use table for Present Value of Lump Sums (pg 241)o $5,135.40 x 0.4632 = $2,378.72

Now, $2684 + $2378.72 = $5063

Valuing Small Businesses Scrutinize

o A/R – remember if it’s on cash basis accounting there should be NO A/Rs, all cash

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o Inventory Leases – make sure assignable (current lease can be valuable)

o PROF: most leases are NOT assignable Fix Assets – get appraisal!

o PROF: in divorce, spouse sometimes tries to hide money, might be booked @ historical cost.

Income Statement – make sure nothing extraordinary on it (just to boost profits)o IE: company fires 10K employees, of course bottom line will look nicer, but productivity

will drop.o Look at Operating Income a lot of small biz owners deduct everything to show low

net profit

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