Bonds - Definition of Terms
Bond Certificate - paper acknowledging the debt (typically has railroad cars on it)
Bond Issue - total amount issued at one time
Bond Indenture - legal document describing the rights of bondholders and restrictions on them
Secured vs. Unsecured - unsecured are call debenture bonds
Term vs. Serial - term comes due at a specified time, serial has payments over time. usually municipal and almost never corporate.
Registered vs. Coupon - almost all are registered now. firm knows who holds them.
Bond rate may be more or less than the market rate for comparably risky assets.
If bond rate is less than market, it will be sold at a discount.
If the bond rate is higher than market, it will be sold at a premium.
Thursday, October 30, 2008
Lecture 8 - Long-term Liabilities
Long-term Liabilities
Management Issues
How do you determine whether to borrow money and increase debt or to issue stock to raise stock. Issuing stock dilutes it. It also may decrease shareholder confidence. It also requires more dividends. Debt, on the other hand, increases risk to the company because there is now a liability to repay the debt. Debt has the benefit that the interest on the debt is tax deductible, whereas the increase in dividends to stockholders is not.
Financial Leverage
This is the excess of the Return on Total Investment over the Interest Rate on Debt. It can be either positive or negative.
Positive leverage allows you to increase your return on equity by borrowing at a rate lower than return on investment.
Negative leverage decreases your ROE when you borrow at a high rate than the ROI.
Interest Coverage
Banks make this calculation in determining how much to lend to a firm.
Amount Available to Pay Interest / Interest Expense
Amount available to pay interest = net income + taxes + interest
(Some ppl add back the depreciation, but we don't and the book doesn't.)
Management Issues
How do you determine whether to borrow money and increase debt or to issue stock to raise stock. Issuing stock dilutes it. It also may decrease shareholder confidence. It also requires more dividends. Debt, on the other hand, increases risk to the company because there is now a liability to repay the debt. Debt has the benefit that the interest on the debt is tax deductible, whereas the increase in dividends to stockholders is not.
Financial Leverage
This is the excess of the Return on Total Investment over the Interest Rate on Debt. It can be either positive or negative.
Positive leverage allows you to increase your return on equity by borrowing at a rate lower than return on investment.
Negative leverage decreases your ROE when you borrow at a high rate than the ROI.
Interest Coverage
Banks make this calculation in determining how much to lend to a firm.
Amount Available to Pay Interest / Interest Expense
Amount available to pay interest = net income + taxes + interest
(Some ppl add back the depreciation, but we don't and the book doesn't.)
Lecture 8 - Long-Term Assets
Definition of Long-Term Assets
Long Term Assets are assets that have a useful life of more than 1 year and are used in the operation of the business (not for investments or for sale to customer). They may be tangible or intangible.
Assets that are for sale to customer are classified as inventory.
Financing
Long-term assets are generally financed for the term of the life of the asset.
If you don't do that, problems can arise, such as the Savings and Loan Crisis of the 1980s.
S&Ls were once limited in their investments. They would invest in local mortgages. In 1980, they were deregulated and they could invest anywhere and in any thing. The mortgages were their assets. The deposits (savings accts and CDs) were their liabilities. CDs typically have short term maturity (less than 5 years). Short term interest went up and the mortgage rates were constant and low. Investors continued to invest in CDs because they were insured by the FDIC. The Resolution Trust Corporation bailed them out.
Accounting for Acquisiton of Long-Term Assets
All costs incurred in the purchase of the asset and preparing it for use are included in the cost. Such as tariffs, cost to tear-down an existing building, legal fees, commissions, delivery charges
Depreciation
Depreciation is used to record wear and tear on the long-term assets over time.
Debit Depreciation Expense
--- Credit Accumulated Depreciation - Equipment
Impairment
You mark down an asset to its fair market value from its carrying value if the fair market value is lower. Carry value = cost-accumulated depreciation. Only write down the value of the asset if the carry value exceeds the undiscounted projected cash flows.
Example: Quaker Oats bought Snapple. But Snapple didn't produce. Nonetheless, the value of Snapple was still higher than its carry value.
This last rule does not conform to internation accounting standards and may be subject to change in the future.
Depreciation
In order to calculate depreciation, you must know
Straight Line Depreciation
In this method:
Depreciation Expense per Year = (1/useful life) x (cost - salvage)
See SE5 page 497
Partial year depreciation is prorated. Note: This type of question (where you have partial year depreciation) is on the final. So, be prepared!
Unit of Production Depreciation
Not used very much, but it's related to depletion.
Amount of depreciation should be relative to the utilization of the asset. Rather than # of years, use this year's activity.
Depreciation expense for Year = (this year's activity/estimated total activity) x (cost - residual value)
See SE6 page 498
After the asset reaches the residual/salvage value, you stop depreciating and leave it on the books at the residual/salvage value.
Double Declining Balance Depreciation
This is primarily used for tax accounting. The idea is that the depreciation is twice the normal depreciation, but use accumulated depreciation instead of salvage value.
Depreciation expense for the year = 2 x (1/useful life) x (cost - accumulated depreciation)
See SE7 page 498
Repairs and Improvements
Normal repairs are expensed.
Debit Repairs Expense
--- Credit Cash
But if the repairs actually extend the useful life of the asset, it's an extraordinary repair and you record it in a way to increase the carry value of the asset.
Debit Accumulated Depreciation
--- Credit Cash
If you literally add on to the asset or make it significantly better, you increase the value of the asset
Debit Asset
--- Credit Cash
Abandonment of an Asset
When you walk away from an asset, you record the abandonment of the asset:
Debit Loss on Abandonment (and expense account)
Debit Accumulated Depreciation (to get that off the books)
--- Credit Asset (to get that off the books)
Sale of an Asset
Depreciate for part of the year
Debit the Loss on Sale or Credit the Gain on Sale
Land
Land is not depreciated. But if you pave it as a parking lot, you would depreciate the pavement cost. If the land comes with a building, separate them out and depreciate the building, but not the land.
Natural Resources
If you buy land for it's minerals or other resources, you depreciate those resources with "depletion".
Depletion expense for the year = (this year's activity/estimated total activity) x (cost - residual value)
This is similar to the unit of production method above.
Intangible Assets
These are assets that are used in the business and have a useful life, but are intangible. Accounting rules changed recently and it was decided that intangible assets should be amortized over time. This is similar to depreciation with tangible assets. Always use straight line method with amortization.
If it has an unlimited useful life, review it at the end of each year for impairment. If it has been impaired, write it down.
Examples: patent, copyright, leasehold, leasehold improvement, trademark, franchise, goodwill, r&d, computer software costs
Patent gives you an exclusive right to sell. US patents do not apply to Europe. If you manufacture in Africa, you don't need a patent unless you will sell there.
Leasehold is the acquisition of the remaining terms of an existing lease, i.e a sublease.
A leasehold improvement is when you improve any property that you lease, either regular or sub lease. Ex: new carpeting or a building on leased property. It's intangible because you don't end up owning these improvements, only the right to use them for the duration of the lease.
Franchise goes on the franchisee's books.
Goodwill
Excess of what you paid over the fair market value of what you acquire in a business transaction.
Record this as:
Debit Assets (at Fair Market Value)
Debit Goodwill
--- Credit Cash
Historically, goodwill was amortized over a period of not more than 40 years. That's the old rule. Around 1999/2000, FASB changed and decided that it must by tested for impairment each year and written down if there is an impairment.
Classic case was Time Warner when they acquired AOL. They paid much more than the FMV of the underlying value - about $120b. When the rule changed and they had to check for impairment, they had to write down $90b. The largest quarterly loss in history.
At about the same time, Enron restated their financial statements by about $80m-$1b. Enron went bankrupt, but AOL/TW stayed in business. How is that possible? It's because people lost trust in Enron, whereas AOL/TW was just a mistake.
Research & Development
R and D is expensed
Computer Software Costs
These costs are also expensed except when you're developing the software for sale. From the point that you determine that there is a market for it, you can capitalize the costs.
US Income Tax Depreciation Rules
This is called modified accelerated cost reduction (MACRS). It's based on tables which are based on the computations that we made earlier - straight-line, unit of production, etc. Real property (fixed in place) is generally straight line. Personal (moveable) property uses declining balance.
Long Term Assets are assets that have a useful life of more than 1 year and are used in the operation of the business (not for investments or for sale to customer). They may be tangible or intangible.
Assets that are for sale to customer are classified as inventory.
Financing
Long-term assets are generally financed for the term of the life of the asset.
If you don't do that, problems can arise, such as the Savings and Loan Crisis of the 1980s.
S&Ls were once limited in their investments. They would invest in local mortgages. In 1980, they were deregulated and they could invest anywhere and in any thing. The mortgages were their assets. The deposits (savings accts and CDs) were their liabilities. CDs typically have short term maturity (less than 5 years). Short term interest went up and the mortgage rates were constant and low. Investors continued to invest in CDs because they were insured by the FDIC. The Resolution Trust Corporation bailed them out.
Accounting for Acquisiton of Long-Term Assets
All costs incurred in the purchase of the asset and preparing it for use are included in the cost. Such as tariffs, cost to tear-down an existing building, legal fees, commissions, delivery charges
Depreciation
Depreciation is used to record wear and tear on the long-term assets over time.
Debit Depreciation Expense
--- Credit Accumulated Depreciation - Equipment
Impairment
You mark down an asset to its fair market value from its carrying value if the fair market value is lower. Carry value = cost-accumulated depreciation. Only write down the value of the asset if the carry value exceeds the undiscounted projected cash flows.
Example: Quaker Oats bought Snapple. But Snapple didn't produce. Nonetheless, the value of Snapple was still higher than its carry value.
This last rule does not conform to internation accounting standards and may be subject to change in the future.
Depreciation
In order to calculate depreciation, you must know
- original cost
- residual value
- useful life
Straight Line Depreciation
In this method:
Depreciation Expense per Year = (1/useful life) x (cost - salvage)
See SE5 page 497
Partial year depreciation is prorated. Note: This type of question (where you have partial year depreciation) is on the final. So, be prepared!
Unit of Production Depreciation
Not used very much, but it's related to depletion.
Amount of depreciation should be relative to the utilization of the asset. Rather than # of years, use this year's activity.
Depreciation expense for Year = (this year's activity/estimated total activity) x (cost - residual value)
See SE6 page 498
After the asset reaches the residual/salvage value, you stop depreciating and leave it on the books at the residual/salvage value.
Double Declining Balance Depreciation
This is primarily used for tax accounting. The idea is that the depreciation is twice the normal depreciation, but use accumulated depreciation instead of salvage value.
Depreciation expense for the year = 2 x (1/useful life) x (cost - accumulated depreciation)
See SE7 page 498
Repairs and Improvements
Normal repairs are expensed.
Debit Repairs Expense
--- Credit Cash
But if the repairs actually extend the useful life of the asset, it's an extraordinary repair and you record it in a way to increase the carry value of the asset.
Debit Accumulated Depreciation
--- Credit Cash
If you literally add on to the asset or make it significantly better, you increase the value of the asset
Debit Asset
--- Credit Cash
Abandonment of an Asset
When you walk away from an asset, you record the abandonment of the asset:
Debit Loss on Abandonment (and expense account)
Debit Accumulated Depreciation (to get that off the books)
--- Credit Asset (to get that off the books)
Sale of an Asset
Depreciate for part of the year
Debit the Loss on Sale or Credit the Gain on Sale
Land
Land is not depreciated. But if you pave it as a parking lot, you would depreciate the pavement cost. If the land comes with a building, separate them out and depreciate the building, but not the land.
Natural Resources
If you buy land for it's minerals or other resources, you depreciate those resources with "depletion".
Depletion expense for the year = (this year's activity/estimated total activity) x (cost - residual value)
This is similar to the unit of production method above.
Intangible Assets
These are assets that are used in the business and have a useful life, but are intangible. Accounting rules changed recently and it was decided that intangible assets should be amortized over time. This is similar to depreciation with tangible assets. Always use straight line method with amortization.
If it has an unlimited useful life, review it at the end of each year for impairment. If it has been impaired, write it down.
Examples: patent, copyright, leasehold, leasehold improvement, trademark, franchise, goodwill, r&d, computer software costs
Patent gives you an exclusive right to sell. US patents do not apply to Europe. If you manufacture in Africa, you don't need a patent unless you will sell there.
Leasehold is the acquisition of the remaining terms of an existing lease, i.e a sublease.
A leasehold improvement is when you improve any property that you lease, either regular or sub lease. Ex: new carpeting or a building on leased property. It's intangible because you don't end up owning these improvements, only the right to use them for the duration of the lease.
Franchise goes on the franchisee's books.
Goodwill
Excess of what you paid over the fair market value of what you acquire in a business transaction.
Record this as:
Debit Assets (at Fair Market Value)
Debit Goodwill
--- Credit Cash
Historically, goodwill was amortized over a period of not more than 40 years. That's the old rule. Around 1999/2000, FASB changed and decided that it must by tested for impairment each year and written down if there is an impairment.
Classic case was Time Warner when they acquired AOL. They paid much more than the FMV of the underlying value - about $120b. When the rule changed and they had to check for impairment, they had to write down $90b. The largest quarterly loss in history.
At about the same time, Enron restated their financial statements by about $80m-$1b. Enron went bankrupt, but AOL/TW stayed in business. How is that possible? It's because people lost trust in Enron, whereas AOL/TW was just a mistake.
Research & Development
R and D is expensed
Computer Software Costs
These costs are also expensed except when you're developing the software for sale. From the point that you determine that there is a market for it, you can capitalize the costs.
US Income Tax Depreciation Rules
This is called modified accelerated cost reduction (MACRS). It's based on tables which are based on the computations that we made earlier - straight-line, unit of production, etc. Real property (fixed in place) is generally straight line. Personal (moveable) property uses declining balance.
Lecture 8 - Capital Budgeting
The PV/FV tables can be used for Capital Budgeting.
Free Cash Flow is cash flow from cash flow from operations minus:
capital purchases
The rest of the cash flow is "free" and available for making capital purchases. How do you decide what to fund?
One way to decide is to evaluate the PV of each proposed project and fund the highest rated. However, this doesn't take into consideration the cost of the projects.
So instead, use Net Present Value, which is the PV minus the cost for the project.
Another way to rate the projects is look at the Internal Rate of Return which is the percentage return for the project.
Note: this is not an exam topic.
Free Cash Flow is cash flow from cash flow from operations minus:
capital purchases
The rest of the cash flow is "free" and available for making capital purchases. How do you decide what to fund?
One way to decide is to evaluate the PV of each proposed project and fund the highest rated. However, this doesn't take into consideration the cost of the projects.
So instead, use Net Present Value, which is the PV minus the cost for the project.
Another way to rate the projects is look at the Internal Rate of Return which is the percentage return for the project.
Note: this is not an exam topic.
Lecture 8 - The Time Value of Money (cont.)
7. Eyeballing it, the first investment will yield more. This is an annuity. Use table 4 to calculate the present value. $110 @ 6% for 3 yrs = 2.673 x 110.
In the second investment, use table 3 for the pv of a single payment. 330 @6% in year 3 = 0.840 x 330
8. In this case, the payments are not even, so the annuity table is useless. You use table 3 twice to find the pv:
pv of 500 @ 10% at end of 2 yrs = 500 x 0.826
pv of 1000 @ 10% at end of 3 yrs = 1000 x 0.751
the sum is 1164
for the second product, use table 4 to find pv of 500 @10% for 3 yrs = 500 x 2.487 = 1243
this should be obvious that the second product is better because you get the return more quickly and the time value of money says that that is more valuable.
9. 5000 now vs 2000 @10% for 3 yrs. use table 4 to get 2000 x 2.487 = ???
this will clearly be less than the 5000
10. this is equivalent of 1% for 24 periods
table typically works with: pv = factor x payment = 21.243 x 1000 = $21,243
In the second investment, use table 3 for the pv of a single payment. 330 @6% in year 3 = 0.840 x 330
8. In this case, the payments are not even, so the annuity table is useless. You use table 3 twice to find the pv:
pv of 500 @ 10% at end of 2 yrs = 500 x 0.826
pv of 1000 @ 10% at end of 3 yrs = 1000 x 0.751
the sum is 1164
for the second product, use table 4 to find pv of 500 @10% for 3 yrs = 500 x 2.487 = 1243
this should be obvious that the second product is better because you get the return more quickly and the time value of money says that that is more valuable.
9. 5000 now vs 2000 @10% for 3 yrs. use table 4 to get 2000 x 2.487 = ???
this will clearly be less than the 5000
10. this is equivalent of 1% for 24 periods
table typically works with: pv = factor x payment = 21.243 x 1000 = $21,243
Thursday, October 23, 2008
Lecture 7 - The Time Value of Money
Main Concept of the Time Value of Money
A dollar received today is worth more to you than a dollar received one year from today. Why? Not because of inflation. Even if there is no inflation because you can take the dollar, invest it and have more money at the end of the year.
Evaluating scenarios in which cash flows are generated at different points in time require us to put a value on having money for some amount of time.
The Four Tables
There are four tables (aka annuity tables) that are used to assess the value of money.
1. The future value (FV) of a dollar received today if I could earn i% per period for n periods.
Formula: FV = PV(1+i)n (Don't worry about the formulas for the exam.)
Example 1: 10 yrs at 10% = 2.594. Multiply that by 386,000 for the final answer.
Don't worry, tables will be provided for the exam.
2. The future value of a dollar received at the end of each period if I could earn i% per period for n periods. (aka future value of an annuity)
Formula: FVa = (PV(1+i)-1)/r
The table assumes annuity is "in arrears" (not annuity "due") - payments are made at the end of the period.
The table can be worked forward (example 2) or backward (example 3).
3. The present value (PV) of a dollar to be received n periods from now. This is essentially the inverse of table 1.
4. The present value of an annuity. This is the inverse of table 2. Do you take the lump sum today or the timed payments?
As the interest rate goes up, the value of the timed payments goes down. And current cash becomes more valuable.
Time Value Quiz has "oddball" questions - non-traditional context.
1. Use table 4 to get present value of the mortgage. 10% for 30 yrs is 9.427. multiply by 10,000 monthly payment = 94,270.
2. How much would remain on the mortgage after the first year? make the same calculation with 29 periods = 93,700. principle went down by 570, rest was interest. uggh!
3. Joe the plumber makes $50k. He can buy his business for $150k. Only consider the excess $100k. 10% for 5 yrs has a present value of 3.791. He should only pay $379,100.
4. Amt of Payment = FV / Factor = 200,000/15.94 (from table 2 - 10% for 10 yrs)
could this be calculated using table 4??
5. we need the present value of an annuity - table 4. use 20 years since it's semiannually (twice a year), but only 5% interest.
6. this is a problem for table 1 - FV of a single sum. ~7-8 years to double your money at 10%. ~14 yrs @ 5%. Shortcut: 72/%rate (x100)
why does this work??
A dollar received today is worth more to you than a dollar received one year from today. Why? Not because of inflation. Even if there is no inflation because you can take the dollar, invest it and have more money at the end of the year.
Evaluating scenarios in which cash flows are generated at different points in time require us to put a value on having money for some amount of time.
The Four Tables
There are four tables (aka annuity tables) that are used to assess the value of money.
1. The future value (FV) of a dollar received today if I could earn i% per period for n periods.
Formula: FV = PV(1+i)n (Don't worry about the formulas for the exam.)
Example 1: 10 yrs at 10% = 2.594. Multiply that by 386,000 for the final answer.
Don't worry, tables will be provided for the exam.
2. The future value of a dollar received at the end of each period if I could earn i% per period for n periods. (aka future value of an annuity)
Formula: FVa = (PV(1+i)-1)/r
The table assumes annuity is "in arrears" (not annuity "due") - payments are made at the end of the period.
The table can be worked forward (example 2) or backward (example 3).
3. The present value (PV) of a dollar to be received n periods from now. This is essentially the inverse of table 1.
4. The present value of an annuity. This is the inverse of table 2. Do you take the lump sum today or the timed payments?
As the interest rate goes up, the value of the timed payments goes down. And current cash becomes more valuable.
Time Value Quiz has "oddball" questions - non-traditional context.
1. Use table 4 to get present value of the mortgage. 10% for 30 yrs is 9.427. multiply by 10,000 monthly payment = 94,270.
2. How much would remain on the mortgage after the first year? make the same calculation with 29 periods = 93,700. principle went down by 570, rest was interest. uggh!
3. Joe the plumber makes $50k. He can buy his business for $150k. Only consider the excess $100k. 10% for 5 yrs has a present value of 3.791. He should only pay $379,100.
4. Amt of Payment = FV / Factor = 200,000/15.94 (from table 2 - 10% for 10 yrs)
could this be calculated using table 4??
5. we need the present value of an annuity - table 4. use 20 years since it's semiannually (twice a year), but only 5% interest.
6. this is a problem for table 1 - FV of a single sum. ~7-8 years to double your money at 10%. ~14 yrs @ 5%. Shortcut: 72/%rate (x100)
why does this work??
Lecture 7 - Liabilities Part 2
Estimated Liabilities
Income Taxes
Financial statements are prepared soon after the beginning of the year, but taxes aren't paid until March 15. So you may not know how much tax you'll pay when you're preparing the financial statement.
Entry for this estimation:
Debit Income Tax Expense (aka provision for income taxes)
------Credit Income Tax Liability
(ACE Question answer is false)
Product Warranties
Product warranties require two types of entries: The end of year adjustment and the provision of warranty services. See class slides for details (which assumes that the warranty provides for replacement of a damaged/defective item and so requires Cr from merchandise inventory)
Contingent Liabilities
Should it be recorded? The criteria are: is it likely to be paid out and can it be estimated?
If so,
Debit Expense related to loss on litigation
---- Credit Contingent Liability relating to litigation
(ACE Question answer is A) Which is not a contingent liability? A dividend declared, but not yet paid. It's a real liability.
Income Taxes
Financial statements are prepared soon after the beginning of the year, but taxes aren't paid until March 15. So you may not know how much tax you'll pay when you're preparing the financial statement.
Entry for this estimation:
Debit Income Tax Expense (aka provision for income taxes)
------Credit Income Tax Liability
(ACE Question answer is false)
Product Warranties
Product warranties require two types of entries: The end of year adjustment and the provision of warranty services. See class slides for details (which assumes that the warranty provides for replacement of a damaged/defective item and so requires Cr from merchandise inventory)
Contingent Liabilities
Should it be recorded? The criteria are: is it likely to be paid out and can it be estimated?
If so,
Debit Expense related to loss on litigation
---- Credit Contingent Liability relating to litigation
(ACE Question answer is A) Which is not a contingent liability? A dividend declared, but not yet paid. It's a real liability.
Lecture 7 - Current Liabilities
Current Liabilities
Days in payables and Payables Turnover are not being covered on the exam and are being skipped in class.
What is a liability? It's an obligation that will require the future resources of the firm.
Typically, what creates a liability is the recognition of an expense. Liabilities are recognized once the firm has an obligation to pay.
By convention, executory contracts are not considered as liabilities and do not appear on the balance sheet. Similarly, lease payments are not reflected on the books as a liability.
Categories of Liabilities
Definitely determinable liabilities: The amount of the liability is clear.
Estimated liabilities: Liabilities which must be estimated in order to know their amounts. Ex: warranty expenses. They're recognized now (even though it's not known if or how much warranty service will need to be delivered) due to the matching principle. Since the sale generated the liability, recognize it at the time of sale.
Contingent Liabilities: Liabilities that may not come into existence. Ex: pending law suits which, if the firm loses, will need to be paid.
Examples of liability accounts
Accounts Payable - There is usually a main, "control" account and subsidiary accounts.
Notes Payable - interest is sometimes stated separately. See class slides for the journal entries for separately stated interest on a loan that was taken, the end of year adjustments and finally the load payoff. (We're skipping the non-separately state interest.)
Liabilities Terminology
Line of credit - An agreement in advance that a bank will lend the firm funds as needed, if the firm maintains good standing with the bank. Not on the balance sheet, but it is disclosed in footnotes. If you use the line of credit, that amount appears under "Notes payable".
Commercial paper - Appears on balance sheet as "Notes payable". (For the lender, it appears as "marketable securities" or "notes receivable" as an asset.)
Accrued liabilities - results from accrued expenses at the end of the year.
Dividends payable - There are 3 associated dates: declaration date, date of record, payment date. The declaration date is the date that the Board of Directors decides that stockholders on the date of record will receive the dividend. The actual payment date may be later.
On the declaration date, Debit Dividends, Credit Dividends payable. Dividends payable is now a current liability. No entry required on the date of record. On the payment date, Debit Dividends payable, Credit Cash.
The "x-dividend" date is the day after the date of record. It indicates that purchasers of the stock on that date (and onward) are no longer entitled to the (current) dividend.
Check with earnings.com. The x-dividend date on earnings.com may be a few days before the date of record because there is a few days lag time between the sale on the exchange and the recording of the sale on the firm's books.
Sales taxes payable: On a sale of a $1 item with 10% tax, the original sale was a Dr. to Cash for $1.10. We need to Cr Sales (revenue account) $1.00 and also Cr. Sales Tax Payable for $0.10.
(ACE Question - Answer is D)
Payroll and Payroll Taxes
The issues with payroll are: What are the accounts? Who pays - employer or employee?
Typical entry is:
Debit Wage Expense
and
Credit all the following accounts -
- employee's FIT (federal income tax) payable - employer must withhold that is expected and send it to the federal government (within 3 days for large employers) not an expense, it's a liability
- employee's SIT (state income tax) payable
- Soc Sec tax payable
- Medicare tax payable - soc sec and medicare total is 7.65%
- Medical insurance payable - employee's contribution to the plan
- Pension contributions payable
- Wages payable or cash - aka take-home pay to the employee
The second major entry is the following
Debit Payroll taxes and benefits expenses
and
Credit all the following accounts
- Soc Sec tax payable (the employer's contribution)
- Medicare tax payable
- Medical insurance payable (if offered by the employer)
- Pension contributions payable (if offered by the employer)
- FUTA payable (Federal unemployment tax) only imposed on the employer, not employee. But the employee gets the benefit, if the employee becomes unemployed.
- SUTA payable (State unemployment tax), state fund generally pays, but if the state fund goes bankrupt, the fed fund pays.
Days in payables and Payables Turnover are not being covered on the exam and are being skipped in class.
What is a liability? It's an obligation that will require the future resources of the firm.
Typically, what creates a liability is the recognition of an expense. Liabilities are recognized once the firm has an obligation to pay.
By convention, executory contracts are not considered as liabilities and do not appear on the balance sheet. Similarly, lease payments are not reflected on the books as a liability.
Categories of Liabilities
Definitely determinable liabilities: The amount of the liability is clear.
Estimated liabilities: Liabilities which must be estimated in order to know their amounts. Ex: warranty expenses. They're recognized now (even though it's not known if or how much warranty service will need to be delivered) due to the matching principle. Since the sale generated the liability, recognize it at the time of sale.
Contingent Liabilities: Liabilities that may not come into existence. Ex: pending law suits which, if the firm loses, will need to be paid.
Examples of liability accounts
Accounts Payable - There is usually a main, "control" account and subsidiary accounts.
Notes Payable - interest is sometimes stated separately. See class slides for the journal entries for separately stated interest on a loan that was taken, the end of year adjustments and finally the load payoff. (We're skipping the non-separately state interest.)
Liabilities Terminology
Line of credit - An agreement in advance that a bank will lend the firm funds as needed, if the firm maintains good standing with the bank. Not on the balance sheet, but it is disclosed in footnotes. If you use the line of credit, that amount appears under "Notes payable".
Commercial paper - Appears on balance sheet as "Notes payable". (For the lender, it appears as "marketable securities" or "notes receivable" as an asset.)
Accrued liabilities - results from accrued expenses at the end of the year.
Dividends payable - There are 3 associated dates: declaration date, date of record, payment date. The declaration date is the date that the Board of Directors decides that stockholders on the date of record will receive the dividend. The actual payment date may be later.
On the declaration date, Debit Dividends, Credit Dividends payable. Dividends payable is now a current liability. No entry required on the date of record. On the payment date, Debit Dividends payable, Credit Cash.
The "x-dividend" date is the day after the date of record. It indicates that purchasers of the stock on that date (and onward) are no longer entitled to the (current) dividend.
Check with earnings.com. The x-dividend date on earnings.com may be a few days before the date of record because there is a few days lag time between the sale on the exchange and the recording of the sale on the firm's books.
Sales taxes payable: On a sale of a $1 item with 10% tax, the original sale was a Dr. to Cash for $1.10. We need to Cr Sales (revenue account) $1.00 and also Cr. Sales Tax Payable for $0.10.
(ACE Question - Answer is D)
Payroll and Payroll Taxes
The issues with payroll are: What are the accounts? Who pays - employer or employee?
Typical entry is:
Debit Wage Expense
and
Credit all the following accounts -
- employee's FIT (federal income tax) payable - employer must withhold that is expected and send it to the federal government (within 3 days for large employers) not an expense, it's a liability
- employee's SIT (state income tax) payable
- Soc Sec tax payable
- Medicare tax payable - soc sec and medicare total is 7.65%
- Medical insurance payable - employee's contribution to the plan
- Pension contributions payable
- Wages payable or cash - aka take-home pay to the employee
The second major entry is the following
Debit Payroll taxes and benefits expenses
and
Credit all the following accounts
- Soc Sec tax payable (the employer's contribution)
- Medicare tax payable
- Medical insurance payable (if offered by the employer)
- Pension contributions payable (if offered by the employer)
- FUTA payable (Federal unemployment tax) only imposed on the employer, not employee. But the employee gets the benefit, if the employee becomes unemployed.
- SUTA payable (State unemployment tax), state fund generally pays, but if the state fund goes bankrupt, the fed fund pays.
Class Discussion Board
Dear Blog Readers
I'm interested in making this more of a two-way conversation. Therefore, I'm thinking of trying a free discussion board application and customizing it for our class and for MBA students in general.
If you're willing to be one of the guinea pigs who will help me test out this technology, please contact me in class or at my gmail address: eliezerappleton.
EA
I'm interested in making this more of a two-way conversation. Therefore, I'm thinking of trying a free discussion board application and customizing it for our class and for MBA students in general.
If you're willing to be one of the guinea pigs who will help me test out this technology, please contact me in class or at my gmail address: eliezerappleton.
EA
Thursday, October 16, 2008
Lecture 6 - Analyzing Financial Statements
Analyzing Financial Statements
Horizontal Analysis
Show Income statement columns for comparable periods. Calculate % increase in an additional column. If you do it for many years, it’s called trend analysis.
Vertical Analysis
Calculate each balance sheet and income statement line as a percentage of Sales. You can trend that out also, combining vertical and horizontal analysis.
Ratio Analysis
Know these ratios! They will be on the final exam! No cheat sheet allowed.
Go to finance.yahoo.com and got to investing – stock investing – stock screener.
Current Ratio = current assets / current liabilities
You would typically want this to be > 1.0
Some companies can have < 1 and still be well run – Walmart and Dell.
Quick Ratio = Very current assets / current liabilities
This is a greater test of whether a company is liquid or not. This ratio will not be on the final exam, but it’s mentioned because Benjamin Graham uses it.
This is calculated by not including prepaid expenses or inventory.
Receivables Turnover = Net Credit Sales / Avg Accts Receivables
Days in Receivables = 365 / Receivables Turnover
Inventory Turnover = COGS / Avg Inventory
Days in Inventory = 365 / Inventory Turnover
Payables Turnover = (COGS +/- in/decrease in inventory) / Avg Accts Payable
Numerator is essentially the purchases
Profitability Ratios
Profit Margin = Net Income / Net Sales
Walmart has small profit margin, but makes it up in large sales volume.
Manufacturing companies like Boeing have much higher profit margins
Asset Turnover = Net Sales / Avg Total Assets
Return on Assets = Net Income / Avg Total Assets
Return on Equity = Net Income / Avg Equity
Equity is almost always lower than assets, so ROE is higher than ROA.
Many ppl would make adjustments to the Net Income numerator in the last two ratios.
Solvency Ratios
Debt to Equity = Total Debt / Avg Total Equity
Utility companies and Lehmann Brothers have high D2E ratio. Many industries have a standard for this ratio that is “expected”.
Interest Coverage = Income before Interest and Taxes / Interest Expense
This measures how capable the firm is of paying off its debt.
Banks certainly look at this ratio when lending.
Cash Flow Adequacy Ratios
Skip the first three: Cash Flow Yield, Cash Flow to Sales, Cash Flow to Assets
Free Cash Flow = Cash Flow from Operations – Dividends – Net Capital Expenditures
Cash Flow from Operations is somewhat difficult to compute. But it is on the statement of cash flows.
Subtract out dividends to keep shareholders happy.
Subtract out maintenance of plant and property so operations can continue in the future.
The rest is not subject to prior commitments. It’s up to managerial discretion on how to spend it.
Not really a ratio. It’s a cash flow computation.
Cash flow can come from 3 sources: Operations, investing, financing.
Next two are not in the book:
EBIT = Earnings before interest and taxes
Net Income + Interest Paid + Taxes
The numerator from Interest Coverage.
Interest = how to finance – high debt or low debt
Taxes = how company is organized – partnership, S corp, etc
This is raw earnings.
EBITDA = Earnings before interest, taxes, depreciation and amortization
Amortization is like depreciation for intangibles. Depreciation and amortization are an expense on the income statement that doesn’t represent a current cash flow. These are non-cash charges that are added back to net income to calculate EBITDA.
These last two, EBIT and EBITDA, are also not ratios.
Market Strength Ratios
Price/Earnings Ratio = Stock Price / Earnings per Share
High ratio indicates that the market values it highly. Others, like Benjamin Graham, target low PE ratio in the hopes that the market will value the company in the future.
Dividend Yield = Dividend / Stock Price
Compare this yield to the interest yield in the bank or other debt instruments.
Horizontal Analysis
Show Income statement columns for comparable periods. Calculate % increase in an additional column. If you do it for many years, it’s called trend analysis.
Vertical Analysis
Calculate each balance sheet and income statement line as a percentage of Sales. You can trend that out also, combining vertical and horizontal analysis.
Ratio Analysis
Know these ratios! They will be on the final exam! No cheat sheet allowed.
Go to finance.yahoo.com and got to investing – stock investing – stock screener.
Current Ratio = current assets / current liabilities
You would typically want this to be > 1.0
Some companies can have < 1 and still be well run – Walmart and Dell.
Quick Ratio = Very current assets / current liabilities
This is a greater test of whether a company is liquid or not. This ratio will not be on the final exam, but it’s mentioned because Benjamin Graham uses it.
This is calculated by not including prepaid expenses or inventory.
Receivables Turnover = Net Credit Sales / Avg Accts Receivables
Days in Receivables = 365 / Receivables Turnover
Inventory Turnover = COGS / Avg Inventory
Days in Inventory = 365 / Inventory Turnover
Payables Turnover = (COGS +/- in/decrease in inventory) / Avg Accts Payable
Numerator is essentially the purchases
Profitability Ratios
Profit Margin = Net Income / Net Sales
Walmart has small profit margin, but makes it up in large sales volume.
Manufacturing companies like Boeing have much higher profit margins
Asset Turnover = Net Sales / Avg Total Assets
Return on Assets = Net Income / Avg Total Assets
Return on Equity = Net Income / Avg Equity
Equity is almost always lower than assets, so ROE is higher than ROA.
Many ppl would make adjustments to the Net Income numerator in the last two ratios.
Solvency Ratios
Debt to Equity = Total Debt / Avg Total Equity
Utility companies and Lehmann Brothers have high D2E ratio. Many industries have a standard for this ratio that is “expected”.
Interest Coverage = Income before Interest and Taxes / Interest Expense
This measures how capable the firm is of paying off its debt.
Banks certainly look at this ratio when lending.
Cash Flow Adequacy Ratios
Skip the first three: Cash Flow Yield, Cash Flow to Sales, Cash Flow to Assets
Free Cash Flow = Cash Flow from Operations – Dividends – Net Capital Expenditures
Cash Flow from Operations is somewhat difficult to compute. But it is on the statement of cash flows.
Subtract out dividends to keep shareholders happy.
Subtract out maintenance of plant and property so operations can continue in the future.
The rest is not subject to prior commitments. It’s up to managerial discretion on how to spend it.
Not really a ratio. It’s a cash flow computation.
Cash flow can come from 3 sources: Operations, investing, financing.
Next two are not in the book:
EBIT = Earnings before interest and taxes
Net Income + Interest Paid + Taxes
The numerator from Interest Coverage.
Interest = how to finance – high debt or low debt
Taxes = how company is organized – partnership, S corp, etc
This is raw earnings.
EBITDA = Earnings before interest, taxes, depreciation and amortization
Amortization is like depreciation for intangibles. Depreciation and amortization are an expense on the income statement that doesn’t represent a current cash flow. These are non-cash charges that are added back to net income to calculate EBITDA.
These last two, EBIT and EBITDA, are also not ratios.
Market Strength Ratios
Price/Earnings Ratio = Stock Price / Earnings per Share
High ratio indicates that the market values it highly. Others, like Benjamin Graham, target low PE ratio in the hopes that the market will value the company in the future.
Dividend Yield = Dividend / Stock Price
Compare this yield to the interest yield in the bank or other debt instruments.
Lecture 6 - Accounting Conventions
Review of the Accounting Cycle
In the last step of the cycle, prepare the financial statements.
Prepare Income Statement first, Statement of Retained Earnings and finally the Balance Sheet.
We’ll cover the Statement of Cash Flows at the end of the course.
Accounting Conventions
Comparability
Financial statements should be comparable from one period to the next and between different companies. Must go out of your way to disclose ways in which they are not comparable – in footnotes and in Auditors’ Opinion.
Financial statements should facilitate comparisons among firms and period to periods comparisons of the same firm.
Consistency
Use the same methods to become comparable. Financial statements should be prepared on a consistent basis to facilitate comparisons. Inconsistencies in the method of preparation should be highlighted.
Materiality
Is it worth our time, effort and money to get the data right down to the last cent? Historically, if it has less than 5% effect on net income, it was considered immaterial. However, lately, this has become insufficient. Enron was an example where several immaterial dollar amounts added up to something that would effect investors and creditors.
In deciding the level of detail to examine and disclose, accountants should take into account whether the detail is likely to affect decision makers.
Conservatism
When in doubt, accountants tend to choose Underestimate income and underestimate net carry value of assets.
Germany is ultra-conservative in this regard due to smaller capital markets and funding being provided primarily by banks.
Full Disclosure
Accountants should attempt to fully disclose all information needed to understand the financial statements.
Cost-Benefit
Balance Sheet Categories
Current Assets
There’s a sub-total called “current assets”. Then all other assets are listed, but not subtotaled and then a grand total of all assets is listed.
Current assets: Cash and assets that are expected to be converted into cash, sold or consumed during the next year or operating cycle, whichever is longer. Typically, a year is longer.
What is the Operating Cycle?
Cash -> Inventory -> Receivables -> back to Cash
Typical current assets:
Cash, account and notes receivables (including installment payments – even if no payments are to be received for more than a year), some investments, inventory, prepayments (usually consumed within the next year)
Investments
Property held as an investment, as opposed to used in the trade or business. Parking lot next door is not an investment.
Property, Plant and Expenses
These are long-lived assets, except for land.
On books at cost and depreciated over their typical life.
Use the Accumulated Depreciation account.
Land is put on the books at cost and not depreciated.
Intangibles
These are long-lived assets without a traditional physical existence, such as patents, franchises, trademarks, etc.
Liabilities
Current liabilities – those that will be satisfied within the next year or operating cycle, whichever is longer.
Long-Term Liabilities
Ex: a long term note which is paid off over more than a year. The portion that will be paid within the current year goes into Current Liabilities.
Owners’ Equity
Contributed capital: Common Stock, Excess over Par, Preferred Stock
Earned capital: Retained Earnings.
Income Statement Categories
Can be either single-step or multi-step statement.
Usually says margin, not “profit”. Groceries stores still use the term profit.
Multi-step:
Sales-COGS = Gross Profit
Gross Profit – Operating Expenses = Net Operating Income
Net Operating Income – Non-Operating Items = Net Income before taxes
Single Step:
List and total all revenues and then list and total all expenses. Net Income before taxes = Revenue – Expenses
In the last step of the cycle, prepare the financial statements.
Prepare Income Statement first, Statement of Retained Earnings and finally the Balance Sheet.
We’ll cover the Statement of Cash Flows at the end of the course.
Accounting Conventions
Comparability
Financial statements should be comparable from one period to the next and between different companies. Must go out of your way to disclose ways in which they are not comparable – in footnotes and in Auditors’ Opinion.
Financial statements should facilitate comparisons among firms and period to periods comparisons of the same firm.
Consistency
Use the same methods to become comparable. Financial statements should be prepared on a consistent basis to facilitate comparisons. Inconsistencies in the method of preparation should be highlighted.
Materiality
Is it worth our time, effort and money to get the data right down to the last cent? Historically, if it has less than 5% effect on net income, it was considered immaterial. However, lately, this has become insufficient. Enron was an example where several immaterial dollar amounts added up to something that would effect investors and creditors.
In deciding the level of detail to examine and disclose, accountants should take into account whether the detail is likely to affect decision makers.
Conservatism
When in doubt, accountants tend to choose Underestimate income and underestimate net carry value of assets.
Germany is ultra-conservative in this regard due to smaller capital markets and funding being provided primarily by banks.
Full Disclosure
Accountants should attempt to fully disclose all information needed to understand the financial statements.
Cost-Benefit
Balance Sheet Categories
Current Assets
There’s a sub-total called “current assets”. Then all other assets are listed, but not subtotaled and then a grand total of all assets is listed.
Current assets: Cash and assets that are expected to be converted into cash, sold or consumed during the next year or operating cycle, whichever is longer. Typically, a year is longer.
What is the Operating Cycle?
Cash -> Inventory -> Receivables -> back to Cash
Typical current assets:
Cash, account and notes receivables (including installment payments – even if no payments are to be received for more than a year), some investments, inventory, prepayments (usually consumed within the next year)
Investments
Property held as an investment, as opposed to used in the trade or business. Parking lot next door is not an investment.
Property, Plant and Expenses
These are long-lived assets, except for land.
On books at cost and depreciated over their typical life.
Use the Accumulated Depreciation account.
Land is put on the books at cost and not depreciated.
Intangibles
These are long-lived assets without a traditional physical existence, such as patents, franchises, trademarks, etc.
Liabilities
Current liabilities – those that will be satisfied within the next year or operating cycle, whichever is longer.
Long-Term Liabilities
Ex: a long term note which is paid off over more than a year. The portion that will be paid within the current year goes into Current Liabilities.
Owners’ Equity
Contributed capital: Common Stock, Excess over Par, Preferred Stock
Earned capital: Retained Earnings.
Income Statement Categories
Can be either single-step or multi-step statement.
Usually says margin, not “profit”. Groceries stores still use the term profit.
Multi-step:
Sales-COGS = Gross Profit
Gross Profit – Operating Expenses = Net Operating Income
Net Operating Income – Non-Operating Items = Net Income before taxes
Single Step:
List and total all revenues and then list and total all expenses. Net Income before taxes = Revenue – Expenses
The Midterm
Midterm Results
Here is the grading "schedule" for the midterm:
75-80 A
71-74 A-
66-70 B+
58-65 B
53-57 B-
45-52 C+
41-44 C
34-40 C-
Below 34 D
The letter grades are not tracked, only your numeric grade. After the final, Prof Sullivan will take both the midterm and final exam grades and average them and create a new "schedule" for those average grades.
My thoughts on the midterm
I thought it was thorough and difficult. All of the answers were more or less straightforward. Nothing really tricky. You either knew it, or you didn't. You just needed to be very precise - which makes sense in an accounting course.
Here is the grading "schedule" for the midterm:
75-80 A
71-74 A-
66-70 B+
58-65 B
53-57 B-
45-52 C+
41-44 C
34-40 C-
Below 34 D
The letter grades are not tracked, only your numeric grade. After the final, Prof Sullivan will take both the midterm and final exam grades and average them and create a new "schedule" for those average grades.
My thoughts on the midterm
I thought it was thorough and difficult. All of the answers were more or less straightforward. Nothing really tricky. You either knew it, or you didn't. You just needed to be very precise - which makes sense in an accounting course.
Thursday, October 2, 2008
Lecture 4 - Investments (cont.)
Accounting for Investments (continued)
The valuation of market price of investment assets is difficult in these times when the market value of many securities has fallen dramatically and there is no liquid market. Some companies claim that the rules in FASB 157 (Fair Value Measurements) are not appropriate for this situation. Financial Accounting Foundation and FASB claims that there is too much pressure from Congress and other governmental agencies. See this article from the FASB web site: http://www.fasb.org/news/2008-FairValue.pdf
Long Term Investments
Available for Sale Securities (less than 20% interest) may be short-term or long-term. In either case, the rules are the same.
If you own more than 20% interest in the investee, you use the Equity Method. Record it at cost and every year, increase or decrease the carrying value by your share of the investees income.
If there's income, debit Investments and credit Income from Investment. If the investee has a loss, debit Loss from Investment and credit Investment.
If the investee pays a dividend, debit Cash and credit Investment.
If you own more than 50% interest in the investee, you treat the two companies as one consolidated whole and issue consolidated financial statement. (Some people say the 50% rule is too low and it shouldn't require consolidation until 60% or higher.) The same thing holds true if the investee is a non-US company. It needs to be consolidated. This is known as "worldwide consolidation". However, you can't consolidate foreign entities for tax accounting.
Debt Securities
There are three categories: trading, available for sale (both of which are treated exactly like equity securities), and held-to-maturity. For held-to-maturity securities, the market value is less relevant since they are going to be held to maturity.
Investment Quiz
The valuation of market price of investment assets is difficult in these times when the market value of many securities has fallen dramatically and there is no liquid market. Some companies claim that the rules in FASB 157 (Fair Value Measurements) are not appropriate for this situation. Financial Accounting Foundation and FASB claims that there is too much pressure from Congress and other governmental agencies. See this article from the FASB web site: http://www.fasb.org/news/2008-FairValue.pdf
Long Term Investments
Available for Sale Securities (less than 20% interest) may be short-term or long-term. In either case, the rules are the same.
If you own more than 20% interest in the investee, you use the Equity Method. Record it at cost and every year, increase or decrease the carrying value by your share of the investees income.
If there's income, debit Investments and credit Income from Investment. If the investee has a loss, debit Loss from Investment and credit Investment.
If the investee pays a dividend, debit Cash and credit Investment.
If you own more than 50% interest in the investee, you treat the two companies as one consolidated whole and issue consolidated financial statement. (Some people say the 50% rule is too low and it shouldn't require consolidation until 60% or higher.) The same thing holds true if the investee is a non-US company. It needs to be consolidated. This is known as "worldwide consolidation". However, you can't consolidate foreign entities for tax accounting.
Debt Securities
There are three categories: trading, available for sale (both of which are treated exactly like equity securities), and held-to-maturity. For held-to-maturity securities, the market value is less relevant since they are going to be held to maturity.
Investment Quiz
Lecture 4 - Investments
Accounting for Investements
We approach investments from the point of view of how a company accounts for their investments in other companies.
The accounting rules depend on whether the investments are debt or equity and whether we classify them as current and non-current. They're broken down this way on the balance sheet. If there are plans to sell the investment within the next year, it's classified as current. Otherwise, it's non-current.
Current investments are assumed to be less than 20% ownership in the investee. Such investments are divided into 2 categories: Trading securities and Available for Sale securities.
Trading Securities are those investments that the company holds to make a short-term profit. Available for Sale were purchases for more long-term investment, but they have now been "marked for market", i.e. to be sold within the next year.
Investments are recorded at market rate. Since there are plans to sell them soon, the market price is the most relevant value. Investments can be written down and then written back up if the price goes back up.
At purchase, debit Investment, credit Cash.
At the end of year, if the value of the investment goes up, debit Allowance to Adjust Securities to Market (a revenue account) and credit Unrealized Gain on Securities.
If the investment value decreases, debit Unrealized Loss on Securities and credit Allowance to Adjust Securities to Market (an expense account).
This is a very controversial topic, perhaps the most controversial, in Financial Accounting today.
We approach investments from the point of view of how a company accounts for their investments in other companies.
The accounting rules depend on whether the investments are debt or equity and whether we classify them as current and non-current. They're broken down this way on the balance sheet. If there are plans to sell the investment within the next year, it's classified as current. Otherwise, it's non-current.
Current investments are assumed to be less than 20% ownership in the investee. Such investments are divided into 2 categories: Trading securities and Available for Sale securities.
Trading Securities are those investments that the company holds to make a short-term profit. Available for Sale were purchases for more long-term investment, but they have now been "marked for market", i.e. to be sold within the next year.
Investments are recorded at market rate. Since there are plans to sell them soon, the market price is the most relevant value. Investments can be written down and then written back up if the price goes back up.
At purchase, debit Investment, credit Cash.
At the end of year, if the value of the investment goes up, debit Allowance to Adjust Securities to Market (a revenue account) and credit Unrealized Gain on Securities.
If the investment value decreases, debit Unrealized Loss on Securities and credit Allowance to Adjust Securities to Market (an expense account).
This is a very controversial topic, perhaps the most controversial, in Financial Accounting today.
Lecture 4 - Accounting for Inventory (cont.)
Midterm Exam is next week
Income Statement - Retained Earnings - Balance Sheet
Calculators will be provided
ACE questions will be useful review
Midterm questions come from the book test bank
Misstatements of Inventory
Fundamental formula for accounting of inventory is:
The consequences to income of misstatements of inventory fall into the following four scenarios:
Overstatement of ending inventory decreases COGS which increases net income. Then, next beginning inventory next year will also be overstated as well. This will increase next year's COGS and decrease next year's net income. Overstating ending inventory takes next year's income and brings it into this year.
Overstatement of beginning inventory increases COGS which decreases net income. This overstatement will not effect next year's income.
Understatement of ending income increases COGS which decreases net income. Next year's beginning income is therefore too low and net income will be too high.
Understatement of beginning inventory decreases COGS which increases net income. Net year's net income is not effected.
Terminology: "Cost of goods available for sale" = Beginning Inventory + Purchases
Lower of Cost or Market
Some companies can use the Lower of Cost or Market technique. (If you use LIFO, you can't use it.) The concept is not to overvalue inventory. Use the lower of cost or market. If cost is lower, use that as usual. If market is lower, mark down the cost to market cost.
When we say "market cost", we refer to the current replacement cost.
In summary, the Lower of Cost or Market rule requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value.
It can be applied item by item or as an aggregate on major categories of items. Item by item will always be equal to or lower than the aggregate method. For tax accounting, you must use the item by item method.
Retail Method
When taking physical inventory, it's often easier to record the retail price and derive the cost from that. We also sometimes want to estimate the ending inventory without making a physical count. To accomplish these goals, we use the Retail Method.
Calculate the ratio of the cost vs. retail of all goods available for sale (=beginning inventory + purchases) and apply that ratio to the ending inventory which you value at retail price to get the cost of ending inventory. However, doing this is very difficult in practice.
Modify the inventory equation to read:
Ending Inventory = Beginning Inventory + Purchases - COGS
Goods Available for sale - Sales = Estimate of Ending Inventory at retail
Then apply the ratio to get the Estimate of Ending Inventory at cost
Gross Profit Method
The Gross Profit Method usually deals with estimating loss due to damaged inventory. Often used for insurance purposes. This method uses the modified inventory equation that we saw above: Ending Inventory = Beginning Inventory + Purchases - COGS. It uses this equation to determine the inventory that was on hand when it was damaged (e.g. by fire, tornado, etc).
Usually, you have records of beginning inventory and purchases from accounting records. You can derive COGS from Sales x Historic Gross Margin, where Gross Margin = Historic (Sales-COGS/Sales).
David H. Brooks
See the case of David Brooks who overstated inventory to hide his theft from the company.
Inventory Quiz
Income Statement - Retained Earnings - Balance Sheet
Calculators will be provided
ACE questions will be useful review
Midterm questions come from the book test bank
Misstatements of Inventory
Fundamental formula for accounting of inventory is:
COGS = Beginning Inventory + Purchases - Ending Inventory
The consequences to income of misstatements of inventory fall into the following four scenarios:
Overstatement of ending inventory decreases COGS which increases net income. Then, next beginning inventory next year will also be overstated as well. This will increase next year's COGS and decrease next year's net income. Overstating ending inventory takes next year's income and brings it into this year.
Overstatement of beginning inventory increases COGS which decreases net income. This overstatement will not effect next year's income.
Understatement of ending income increases COGS which decreases net income. Next year's beginning income is therefore too low and net income will be too high.
Understatement of beginning inventory decreases COGS which increases net income. Net year's net income is not effected.
Terminology: "Cost of goods available for sale" = Beginning Inventory + Purchases
Lower of Cost or Market
Some companies can use the Lower of Cost or Market technique. (If you use LIFO, you can't use it.) The concept is not to overvalue inventory. Use the lower of cost or market. If cost is lower, use that as usual. If market is lower, mark down the cost to market cost.
When we say "market cost", we refer to the current replacement cost.
In summary, the Lower of Cost or Market rule requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value.
It can be applied item by item or as an aggregate on major categories of items. Item by item will always be equal to or lower than the aggregate method. For tax accounting, you must use the item by item method.
Retail Method
When taking physical inventory, it's often easier to record the retail price and derive the cost from that. We also sometimes want to estimate the ending inventory without making a physical count. To accomplish these goals, we use the Retail Method.
Calculate the ratio of the cost vs. retail of all goods available for sale (=beginning inventory + purchases) and apply that ratio to the ending inventory which you value at retail price to get the cost of ending inventory. However, doing this is very difficult in practice.
Modify the inventory equation to read:
Ending Inventory = Beginning Inventory + Purchases - COGS
Goods Available for sale - Sales = Estimate of Ending Inventory at retail
Then apply the ratio to get the Estimate of Ending Inventory at cost
Gross Profit Method
The Gross Profit Method usually deals with estimating loss due to damaged inventory. Often used for insurance purposes. This method uses the modified inventory equation that we saw above: Ending Inventory = Beginning Inventory + Purchases - COGS. It uses this equation to determine the inventory that was on hand when it was damaged (e.g. by fire, tornado, etc).
Usually, you have records of beginning inventory and purchases from accounting records. You can derive COGS from Sales x Historic Gross Margin, where Gross Margin = Historic (Sales-COGS/Sales).
David H. Brooks
See the case of David Brooks who overstated inventory to hide his theft from the company.
Inventory Quiz
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