Accounting
Financial statements, accrual accounting, adjusting entries, and cash flow analysis (BADM 210)
LO1: Who Uses Accounting Information?
External and internal decision-makers; costs and benefits of disclosure
What is Accounting?
Accounting is the process of recording, summarizing, and analyzing financial transactions to help people make economic decisions.
Financial Accounting
Designed primarily for decision-makers outside the company (investors, creditors, regulators). Reports on past performance.
Managerial Accounting
Designed primarily for decision-makers within the company (managers). Supports internal planning and control.
Decision Makers and Their Questions
| User | Decision | Information Needed |
|---|---|---|
| Shareholders / Investors | Buy, sell, or hold stock? | Profitability, growth potential, dividends, ROE |
| Creditors (banks, bondholders) | Lend? At what rate? How much collateral? | Solvency, cash flows, debt levels, ability to repay |
| Suppliers | Extend credit terms? Long-term supply relationship? | Financial stability, ability to pay obligations |
| Management | Evaluate performance; plan strategy; earn bonuses | Operating results, cost data, efficiency metrics |
| Board of Directors | Oversee management; assess strategy; represent shareholders | Full financial statements; management performance |
| Regulators / Government | Tax compliance; market oversight | Revenues, expenses, assets, disclosures |
Costs and Benefits of Disclosure
Benefits
- Lower borrowing costs (lower interest rates)
- Better supplier terms (long-term relationships)
- Increased investor confidence and access to capital
Costs
- Hiring accountants to prepare statements
- Competitors gain access to strategic information
- Political costs — increased regulation and taxes
LO2: Business Activities & the Accounting Equation
Planning, investing, financing, and operating activities
Four Business Activities
Planning
Setting goals and strategies. Primary goal: create value for owners.
Investing
Acquiring and disposing of assets (resources) used to produce products/services. Short-term assets (inventory) and long-term assets (equipment, buildings).
Financing
Funding investments. Two external sources: debt financing (creditors) and equity financing (owners). Financial management = planning the proper mix.
Operating
Producing, promoting, and selling products/services. Generates revenues and incurs expenses. Net Income = Revenues − Expenses.
The Accounting Equation
Assets = Liabilities + Equity
Creditor Financing + Owner Financing = Economic Resources
| Term | Definition | Nike FY2020 Example |
|---|---|---|
| Assets | Economic resources owned or controlled by the company that provide future benefits | $31,342M |
| Liabilities | Non-owner claims on assets; obligations to creditors (debt financing) | $23,287M |
| Equity | Owner claims on assets; residual interest after liabilities are satisfied | $8,055M |
Operating equation: Net Income = Revenues − Expenses (Nike FY2020: $2,539M = $37,403M − $34,864M)
LO3: The Four Financial Statements
Balance sheet, income statement, stockholders' equity, and cash flows
Balance Sheet
A.K.A. Statement of Financial Position
Point in timeAssets = Liabilities + Equity. Lists all investments (assets) and how they were financed (liabilities + equity). A snapshot of financial position on a specific date.
Assets = Liabilities + EquityIncome Statement
A.K.A. P&L / Statement of Operations / Statement of Earnings
Period of timeReports operating results. Revenues come from business activities; expenses are the cost of generating those revenues.
Revenues − Expenses = Net IncomeStatement of Stockholders' Equity
A.K.A. Equity Reconciliation
Period of timeShows changes in equity: contributed capital (stock issued) and earned capital (retained earnings). Retained earnings = cumulative net income − cumulative dividends.
Beg. RE + Net Income − Dividends = End. REStatement of Cash Flows
A.K.A. Cash Flow Statement
Period of timeReports actual cash in and out across operating, investing, and financing activities. Cash from operations often differs from net income due to accrual accounting timing.
Operating + Investing + Financing Cash FlowsFinancial Statement Articulation
The four statements are linked — called articulation. Net income flows into retained earnings; retained earnings flows to equity on the balance sheet; ending cash on the cash flow statement equals cash on the balance sheet.
Statement linkage chain:
Reporting periodscan be annual (fiscal year), quarterly, or monthly. Nike's fiscal year ends May 31.
LO4: Regulation & Accounting Standards
GAAP, SEC, FASB, SOX, and IFRS
| Body / Standard | Full Name | Role |
|---|---|---|
| GAAP | Generally Accepted Accounting Principles | Standards and accepted practices guiding U.S. financial statement preparation. Allows some discretion but ensures comparability. |
| SEC | Securities & Exchange Commission (created by Securities Act of 1934) | Regulates issuance and trading of U.S. securities. Companies with >$10M assets and >500 owners must file annual reports. |
| FASB | Financial Accounting Standards Board | Currently establishes U.S. accounting standards (GAAP). Developed the Conceptual Framework for unaddressed issues. |
| SOX | Sarbanes-Oxley Act (2002) | Congressional response to accounting scandals (Enron). Increases confidence in financial reporting. Established PCAOB. |
| PCAOB | Public Company Accounting Oversight Board | Created by SOX. Approves auditing standards and monitors quality of financial statements and audits. |
| IASB / IFRS | International Accounting Standards Board / International Financial Reporting Standards | Sets international standards. No legal enforcement power but widely adopted outside the U.S. Growing convergence with GAAP. |
Management's Role
- Prepares the financial statements
- Takes legal responsibility for disclosures
Independent Auditors' Role
- "Audit" financial statements for accuracy and completeness
- Publicly traded companies must have audits by an independent firm
- An audit opinion is assurance, not a guarantee
LO5: Key Financial Ratios
Return on equity (profitability) and debt-to-equity (risk)
Return on Equity (ROE)
Measures profitability — how efficiently equity is used to generate profit
- Higher ROE = more profitable use of owner capital
- Compare to prior periods and industry peers
- Nike's ROE declined in FY2020 vs. prior year
Debt-to-Equity Ratio
Measures credit risk / solvency — how much debt is used relative to equity
- Higher D/E = more leveraged, more financial risk
- Solvency: ability to remain in business and avoid bankruptcy
- Nike's D/E ratio increased between 2018 and 2020
LO1: Balance Sheet Structure
Assets, liabilities, and stockholders' equity components
Assets
Resources expected to provide future economic benefits. Must be owned/controlled by the company and have measurable monetary value.
Current Assets (due within 1 year) — listed by liquidity
- • Cash — currency, deposits, cash equivalents
- • Marketable securities — short-term investments
- • Accounts receivable — amounts owed by customers
- • Inventory — goods purchased or produced for sale
- • Prepaid expenses — rent, insurance paid in advance
Noncurrent Assets (long-term)
- • Long-term financial investments
- • PP&E — land, buildings, equipment (net of depreciation)
- • Operating lease ROU assets
- • Intangibles — patents, trademarks, goodwill
Reported at historical cost (reliable but may undervalue). Some assets (marketable securities) reported at fair value.
Liabilities
Obligations to external parties. Recognized when: (1) future sacrifice probable, (2) amount known/estimable, (3) obligating event occurred.
Current Liabilities (due within 1 year)
- • Accounts payable — owed to suppliers for credit purchases
- • Accrued liabilities — expenses recorded but unpaid
- • Short-term borrowings — short-term bank debt
- • Deferred (unearned) revenue — cash received, service not yet delivered
- • Current maturities of LT debt — portion of LT debt due this year
Noncurrent Liabilities
- • Long-term debt — repaid beyond 1 year
- • Operating lease obligations (long-term portion)
- • Other LT liabilities — warranties, deferred tax
Stockholders' Equity
Contributed Capital:
- • Common stock — par/stated value of shares issued
- • Additional paid-in capital — amount received above par
- • Treasury stock — cost of repurchased shares (deducted)
Earned Capital:
- • Retained earnings — cumulative income not paid as dividends
- • AOCI — accumulated other comprehensive income
Retained Earnings Formula
Net income increases retained earnings; a net loss decreases it. Reported in the stockholders' equity section of the balance sheet.
LO2: Transaction Analysis & FSET
Financial Statement Effects Template and the Jana Juice example
Financial Statement Effects Template (FSET)
The FSET captures each transaction's effect on the balance sheet and income statement simultaneously. The balance sheet must always remain in balance: Assets = Liabilities + Equity.
| Transaction | Balance Sheet | Income Statement | |||||
|---|---|---|---|---|---|---|---|
| Cash Asset | + Noncash Asset | = Liabilities | + Contrib. + Earned Capital | Revenues | − Expenses | = Net Income | |
| e.g., Sell inventory for cash | +2,400 | −600 Inv. | — | +1,800 RE | +2,400 | +600 | +1,800 |
Jana Juice — 15 Transactions (May)
Jana Juice is a startup energy drink company. Transactions 1–15 occurred in May (first month of operations).
| # | Transaction | Key Account Effects |
|---|---|---|
| 1 | Issued 500 shares of stock for $10,000 cash | Cash +10,000 | Common Stock +10,000 |
| 2 | Borrowed $4,000 (note payable, repay May 31 + $40 interest) | Cash +4,000 | Notes Payable +4,000 |
| 3 | Paid $1,800 security deposit for store rental | Cash −1,800 | Security Deposit +1,800 |
| 4 | Purchased $2,000 inventory on account | Inventory +2,000 | Accounts Payable +2,000 |
| 5 | Paid $900 for newspaper advertising in May | Cash −900 | Advertising Expense +900 | RE −900 |
| 6 | Paid $1,500 on accounts payable | Cash −1,500 | Accounts Payable −1,500 |
| 7 | Sold $600 of inventory for $2,400 cash | Cash +2,400 | Inventory −600 | Revenue +2,400 | COGS +600 |
| 8 | Sold $700 of inventory on account for $2,900 | AR +2,900 | Inventory −700 | Revenue +2,900 | COGS +700 |
| 9 | Paid $1,300 in wages to employees | Cash −1,300 | Wages Expense +1,300 | RE −1,300 |
| 10 | Received $300 for 3-month online health membership (June–Aug) | Cash +300 | Unearned Revenue +300 (liability — not yet earned) |
| 11 | Collected $1,200 from customers on account | Cash +1,200 | Accounts Receivable −1,200 |
| 12 | Repaid $4,000 note payable + $40 interest | Cash −4,040 | Notes Payable −4,000 | Interest Expense +40 | RE −40 |
| 13 | Paid $800 for 4-month insurance policy (prepaid) | Cash −800 | Prepaid Insurance +800 |
| 14 | Paid $700 rent for May | Cash −700 | Rent Expense +700 | RE −700 |
| 15 | Paid $400 dividends to shareholders | Cash −400 | Retained Earnings −400 (no effect on net income) |
LO3: The Income Statement
Reporting financial performance for a period
Income Statement Format
Revenues = increases in net assets from business activities.
Expenses = outflow or use of assets to generate revenues.
Nonoperating items (interest revenue/expense) are segregated because they relate to financing/investing, not core operations.
Jana Juice Income Statement (May)
Revenue = txn 7 ($2,400) + txn 8 ($2,900) = $5,300.
COGS = txn 7 ($600) + txn 8 ($700) = $1,300.
LO4: Accrual Accounting
Revenue and expense recognition principles; retained earnings articulation
Revenue Recognition
Recognize revenue when goods or services are transferred to the customer — not when cash is received.
Example:
Target sells $140,000 of goods in May (collecting $130,000 cash; $10,000 promised in June).
Revenue recognized in May = $140,000
(Not $130,000 — delivery, not cash receipt, triggers recognition)
Expense Recognition (Matching Principle)
Recognize expenses when assets decrease (or liabilities increase) as a result of generating revenue — match costs to the revenue they helped earn.
Example:
Target bought $80,000 of inventory; sold $70,000 worth for $120,000 during May (paid $65,000; owes $15,000).
COGS recognized in May = $70,000
(The $70,000 sold, not the $65,000 paid)
Retained Earnings Articulation
Net income from the income statement flows into retained earnings in the Statement of Stockholders' Equity, linking the income statement to the balance sheet across periods (articulation).
(Target Corporation, year ended January 29, 2022 — $ millions)
LO5: Equity Transactions & Statement of Stockholders' Equity
Dividends, stock issuances, and equity reconciliation
Key Points
- Dividends reduce retained earnings but have no effect on net income — they are a distribution of profit, not an expense
- The Statement of Stockholders' Equity reconciles beginning and ending equity balances
- Total equity = Contributed Capital + Earned Capital
- Retained earnings begins at zero for a new company and accumulates over time
Jana Juice — Statement of Stockholders' Equity (May)
| Item | Contrib. Capital | Earned Capital (RE) | Total |
|---|---|---|---|
| Balance, May 1 | $— | $— | $— |
| Common stock issued | 10,000 | — | 10,000 |
| Net income | — | 1,060 | 1,060 |
| Cash dividends | — | (400) | (400) |
| Balance, May 31 | $10,000 | $660 | $10,660 |
Jana Juice — Balance Sheet (May 31)
LO6: Journal Entries & T-Accounts
Debits, credits, and double-entry accounting
T-Account Format
A graphic representation of an account used to record increases and decreases.
Debit (Dr)
Always on the Left
Credit (Cr)
Always on the Right
Double-entry accounting: Every transaction affects at least two accounts. Total debits must always equal total credits.
Normal Balances Summary
| Account Type | Normal Balance | Increase via | Decrease via |
|---|---|---|---|
| Assets | Debit | Debit (Dr) | Credit (Cr) |
| Expenses | Debit | Debit (Dr) | Credit (Cr) |
| Dividends | Debit | Debit (Dr) | Credit (Cr) |
| Liabilities | Credit | Credit (Cr) | Debit (Dr) |
| Equity | Credit | Credit (Cr) | Debit (Dr) |
| Revenues | Credit | Credit (Cr) | Debit (Dr) |
Journal Entry Format
Record debits first; credits are indented. Example: Jana Juice Transaction 7 (sold inventory for cash):
Amounts are then posted from journal entries to the corresponding T-accounts in the general ledger.
LO7: Liquidity Ratios
Measuring a company's ability to pay short-term obligations
Liquidity is the ability to pay debts when due. The larger current assets are relative to current liabilities, the more liquid the company.
Net Working Capital
Positive NWC = can cover short-term obligations from current assets. Negative NWC signals potential liquidity problems.
Current Ratio
Ratio > 1 means current assets exceed current liabilities. Benchmark varies by industry. Declining trend signals worsening liquidity.
Quick Ratio
Quick Assets = Cash + Marketable Securities + Accounts Receivable (excludes inventory and prepaid expenses — less liquid). More conservative than current ratio.
Operating Cycle
The time between paying cash for goods/services and receiving cash from customers. The amount of working capital needed depends on the length of the operating cycle — longer cycles require more working capital.
Example: Cash → Buy inventory → Sell on credit → Collect from customer → Cash (cycle repeats)
LO1: The Accounting Cycle
Steps from transaction to financial statements; Jana Juice June transactions
Abbreviated Accounting Cycle
A systematic process repeated each fiscal period for accumulating and reporting financial data:
Accounting Documents
General Journal
Tabular, chronological record where business activities are captured as debits and credits. Each entry shows date, accounts, amounts, and description.
General Ledger (Chart of Accounts)
Listing of all accounts and their running balances. Accounts grouped by element: Assets, Liabilities, Equity, Revenues, Expenses.
Jana Juice — June Transactions (1–12)
June is Jana Juice's second month of operations. These are the regular (pre-adjustment) transactions.
| # | Transaction | Key Account Effects |
|---|---|---|
| 1 | Signed 2-year note; borrowed $12,000 at 12% annual interest | Cash +12,000 | Notes Payable +12,000 |
| 2 | Purchased and installed fixtures & equipment for $10,200 cash | Cash −10,200 | Fixtures & Equipment +10,200 |
| 3 | Paid $800 for newspaper advertising in June | Cash −800 | Advertising Expense +800 |
| 4 | Paid $500 to suppliers for May inventory (accounts payable) | Cash −500 | Accounts Payable −500 |
| 5 | Purchased $2,600 inventory on account | Inventory +2,600 | Accounts Payable +2,600 |
| 6 | Sold $600 of inventory for $3,100 cash | Cash +3,100 | Inventory −600 | Sales Revenue +3,100 | COGS +600 |
| 7 | Sold $1,100 of inventory on account for $4,400 | Accounts Receivable +4,400 | Inventory −1,100 | Sales Revenue +4,400 | COGS +1,100 |
| 8 | Received $600 for 3-month online membership (July–Sept) | Cash +600 | Unearned Revenue +600 (liability — not yet earned) |
| 9 | Paid $1,400 wages to employees | Cash −1,400 | Wages Expense +1,400 |
| 10 | Received $2,000 cash from credit customers | Cash +2,000 | Accounts Receivable −2,000 |
| 11 | Paid $700 rent for June | Cash −700 | Rent Expense +700 |
| 12 | Declared and paid $100 cash dividends | Cash −100 | Retained Earnings −100 (no effect on net income) |
LO2: Adjusting Entries
Deferrals, accruals, depreciation, and income taxes
Why adjust?
- Accrual accounting requires matching revenues and expenses to the correct period
- Adjustments occur after all regular transactions, before financial statements
- Almost never affect Cash
- Always affect at least one BS account and one IS account
Two broad types:
Deferrals
Amount was already recorded in a BS account. Adjustment moves it to IS. Decreases BS, increases IS.
Accruals
Amount was NOT previously recorded. Adjustment adds it to both BS and IS. Increases both.
Unadjusted Trial Balance (June 30, before adjustments)
| Account | Debit | Credit |
|---|---|---|
| Cash | $10,460 | |
| Accounts Receivable | $4,100 | |
| Inventory | $1,600 | |
| Prepaid Insurance | $800 | |
| Security Deposit | $1,800 | |
| Fixtures and Equipment | $10,200 | |
| Accounts Payable | $2,600 | |
| Unearned Revenue | $900 | |
| Long-term Notes Payable | $12,000 | |
| Common Stock | $10,000 | |
| Retained Earnings | $560 | |
| Sales Revenue | $7,500 | |
| Cost of Goods Sold | $1,700 | |
| Wages Expense | $1,400 | |
| Rent Expense | $700 | |
| Advertising Expense | $800 | |
| Totals | $33,560 | $33,560 |
Jana Juice June Adjustments (a–g)
1 month of the May $300 three-month membership is earned in June
Unearned Revenue (−L): $100 → Sales Revenue (+R, +SE): $100
$300 ÷ 3 months = $100/month
1 month of the 4-month insurance policy ($800) expires in June
Insurance Expense (+E, −SE): $200 → Prepaid Insurance (−A): $200
$800 ÷ 4 months = $200/month
Equipment ($10,200) depreciates over 5 years straight-line
Depreciation Expense (+E, −SE): $170 → Accumulated Depreciation (+XA, −A): $170
$10,200 ÷ 5 yrs ÷ 12 mo = $170/month
Bank credited $60 interest to Jana Juice checking account; will deposit on July 5
Interest Receivable (+A): $60 → Interest Income (+R, +SE): $60
Interest earned in June, cash received in July
Employees earned $550 in last week of June, to be paid July 6
Wages Expense (+E, −SE): $550 → Wages Payable (+L): $550
Expense incurred in June, cash paid in July
June interest on $12,000 note at 12% annual rate (paid on 1st of each month)
Interest Expense (+E, −SE): $120 → Interest Payable (+L): $120
$12,000 × 12% × 1/12 = $120
Income before taxes = $2,020; tax rate 25% = $505; taxes paid following month
Income Tax Expense (+E, −SE): $505 → Income Tax Payable (+L): $505
$2,020 × 25% = $505
Accumulated Depreciation — Contra Asset Account
Instead of reducing the Equipment account directly, depreciation is accumulated in a separate contra asset account. On the balance sheet: Fixtures & Equipment $10,200 − Accumulated Depreciation ($170) = Net book value $10,030. The contra account lets users see both the original cost and total depreciation taken.
LO3: Financial Statements from Adjusted Accounts
Income statement, equity statement, balance sheet, and cash flows (June)
Income Statement (June)
Statement of Stockholders' Equity (June)
| Item | Contrib. | Earned (RE) | Total |
|---|---|---|---|
| Balance, June 1 | $10,000 | $660 | $10,660 |
| Net income | — | 1,515 | 1,515 |
| Cash dividends | — | (100) | (100) |
| Balance, June 30 | $10,000 | $2,075 | $12,075 |
Statement of Cash Flows (June)
Balance Sheet (June 30)
LO4: Closing Temporary Accounts
Zeroing out income statement accounts; post-closing trial balance
Permanent vs. Temporary Accounts
Permanent (Balance Sheet)
Assets, Liabilities, Equity — carry balances forward each period. Never closed.
Temporary (Income Statement + Dividends)
Revenues, Expenses, Dividends — reset to zero at end of each period. Balances transferred to Retained Earnings.
Two Closing Entries
- Close revenue accounts: Debit each revenue account (zero it out); Credit Retained Earnings for total revenues.
- Close expense accounts: Credit each expense account (zero it out); Debit Retained Earnings for total expenses.
Note: Dividends are already debited to RE when declared (transaction 12), so they don't need a separate closing entry in this example.
Jana Juice Closing Entries (June 30)
Retained Earnings after closing:
Post-Closing Trial Balance (June 30)
Only permanent (balance sheet) accounts remain. All temporary accounts have zero balances.
| Account | Debit | Credit |
|---|---|---|
| Cash | $10,460 | |
| Accounts Receivable | $4,100 | |
| Inventory | $1,600 | |
| Prepaid Insurance | $600 | |
| Interest Receivable | $60 | |
| Security Deposit | $1,800 | |
| Fixtures and Equipment | $10,200 | |
| Accum. Depreciation—Fixtures | $170 | |
| Accounts Payable | $2,600 | |
| Unearned Revenue | $800 | |
| Wages Payable | $550 | |
| Interest Payable | $120 | |
| Income Tax Payable | $505 | |
| Notes Payable | $12,000 | |
| Common Stock | $10,000 | |
| Retained Earnings | $2,075 | |
| Totals | $28,820 | $28,820 |
LO5: Levels & Flows Analysis
Using balance sheet levels and income statement flows together
Levels (Balance Sheet)
Represent the stock of resources at a point in time. A snapshot.
Examples: Cash on hand, Inventory balance, Accounts Receivable, Accounts Payable
Flows (Income Statement / SCF)
Represent the change in resources over a period of time. Activity during the period.
Examples: Sales Revenue, COGS, Wages Expense, Cash from Operations
The Relationship
This relationship is fundamental to accounting. It underlies the accounting equation and connects the balance sheet to the income statement and cash flow statement across periods.
Example: Office Supplies
A service business has office supplies on hand. Given balance sheet levels and purchase data, calculate the expense (flow):
| Known Information | Amount |
|---|---|
| Supplies on hand, July 1 (beginning level) | $2,400 |
| Supplies purchased during Q3 (flow in) | $5,700 |
| Supplies on hand, Sept 30 (ending level) | $1,900 |
| Supplies used as expense (flow out) = $2,400 + $5,700 − $1,900 | $6,200 |
LO1: Purpose & Classification of Cash Flows
Why the SCF matters and how transactions are categorized
Purpose of the Statement of Cash Flows
- Shows how a company generates and uses cash — fills the gap between accrual net income and actual cash
- Helps assess ability to settle liabilities and pay dividends
- Helps determine the company's need for outside financing
- Permits users to observe and assess management's investing and financing policies
Three Activity Categories
Operating Activities
Selling goods or rendering services — primary day-to-day business activities
Inflows:
Cash from customers, interest received, dividends received
Outflows:
Payments to suppliers, employees, interest paid, taxes paid
Investing Activities
Acquiring and disposing of long-term assets and investments
Inflows:
Sale of PP&E, sale of investments, collection of loans made
Outflows:
Purchase of PP&E, purchase of investments, loans made to others
Financing Activities
Receiving/returning cash to shareholders; borrowing/repaying creditors
Inflows:
Issuance of stock, proceeds from borrowing
Outflows:
Dividends paid, repurchase of stock, repayment of loans
Cash Equivalents
Short-term, highly liquid investments that are:
- Easily convertible to a known cash amount
- Close enough to maturity that market value isn't sensitive to interest rate changes
- Generally maturity of 3 months or less
Examples: money market accounts, T-bills, commercial paper
Usefulness of Classifications
Three companies each generate $100,000 of cash, but from different sources:
- From operations → recurring, can sustain the company
- From selling assets → not likely to recur; will replacements be needed?
- From borrowing → repayment required; increases debt burden
LO2: Operating Activities — Direct Method
Examining and classifying individual cash transactions
Direct Method
Examine all cash transactions that occur during the period and group them by activity (operating, investing, financing). Lists each cash receipt and payment category directly.
Jana Juice May Transaction Classification
| Transaction | Category |
|---|---|
| Issued stock for $10,000 cash | Financing |
| Borrowed $4,000 on note payable | Financing |
| Paid $1,800 security deposit | Operating |
| Purchased $2,000 inventory on account (no cash yet) | — |
| Paid $900 for advertising | Operating |
| Paid $1,500 to suppliers (accounts payable) | Operating |
| Sold drinks for $2,400 cash | Operating |
| Sold drinks on account — $2,900 (no cash yet) | — |
| Paid $1,300 wages | Operating |
| Received $300 for 3-month membership (cash in) | Operating |
| Collected $1,200 from credit customers | Operating |
| Repaid $4,000 note + $40 interest ($4,040 total) | Financing ($4,000) / Operating ($40) |
| Paid $800 for 4-month insurance policy | Operating |
| Paid $700 rent | Operating |
| Paid $400 dividends | Financing |
Operating Cash Flows — Direct Method (May)
Net operating cash flow is negative in May because Jana Juice is a startup investing in its business. This is normal — operating cash flows typically turn positive as the business matures.
LO3: Operating Activities — Indirect Method
Reconciling accrual net income to cash from operations
Direct vs. Indirect
Both methods report the same cash from operations — they just present it differently.
- Direct: lists each cash receipt/payment category directly
- Indirect: starts with net income, adjusts for noncash items and WC changes
- Indirect is used by >95% of companies (easier, less disclosure required)
Why Adjust Net Income?
Net income (accrual basis) ≠ cash from operations because:
- Revenue recognized ≠ cash collected (changes in AR, unearned revenue)
- Expenses incurred ≠ cash paid (changes in AP, wages payable, prepaid)
- Depreciation expense reduces income but requires no cash
Key Adjustment Rules
| Adjustment | Rule | Logic |
|---|---|---|
| Depreciation expense | Add back to net income | Non-cash expense — reduces income but never reduces cash |
| Increase in current asset (e.g., AR, Inventory) | Subtract from net income | Cash collected < revenue recognized (or cash paid > expense) |
| Decrease in current asset | Add to net income | Collected more cash than recognized as revenue (or paid less than expensed) |
| Increase in current liability (e.g., AP, wages payable) | Add to net income | Incurred expense but haven't paid cash yet |
| Decrease in current liability | Subtract from net income | Paid more cash than what was expensed this period |
| Gains on asset sales (investing) | Subtract from net income | Gain is part of investing, not operating; remove to avoid double-counting |
| Losses on asset sales (investing) | Add to net income | Loss is part of investing, not operating; remove to avoid double-counting |
Jana Juice June — Indirect Method Reconciliation
Net income here ($1,414) reflects Ch4's assumptions; the result ($2,300 cash from operations) matches the direct method.
LO4: Investing & Financing Activities
Analyzing balance sheet changes to identify investing and financing cash flows
Investing Activities
Cause changes in noncurrent asset accounts not already captured in operating activities.
Analysis rule:
Asset increases → cash outflow (bought something)
Asset decreases → cash inflow (sold something)
Jana Juice June (Investing):
Equipment increased from $0 to $10,200 → Cash outflow: $(10,200)
Financing Activities
Cause changes in financing liabilities and stockholders' equity accounts not in operating activities.
Analysis rule:
Liability or equity increases → cash inflow (borrowed or issued stock)
Liability or equity decreases → cash outflow (repaid debt or paid dividends)
Jana Juice June (Financing):
Notes payable +$12,000 → +$12,000 inflow
Dividends paid → −$100 outflow
Jana Juice — Complete Statement of Cash Flows (June, Indirect Method)
Net change in cash = $2,300 + (−$10,200) + $11,900 = $4,000. Ending cash = $6,460 + $4,000 = $10,460 ✓ (matches balance sheet).
LO5: Noncash Activities & Supplemental Disclosures
Gains, losses, noncash transactions, and required disclosures
Gains and Losses on Asset Sales
FASB requires investing and financing items be reported at gross cash amounts:
Gain
Asset sold for more than book value → recorded as a special revenue. The gain is removed from operating activities and the full proceeds appear in investing activities.
Loss
Asset sold for less than book value → recorded as a special expense. The loss is removed from operating activities and proceeds appear in investing activities.
In the indirect method, gains are subtracted and losses are added back when converting to cash from operations.
Noncash Investing & Financing Activities
Significant transactions that affect long-term assets, liabilities, or equity but do not directly affect cash:
- Issue stock in exchange for land (no cash changes hands)
- Purchase a building by signing a long-term note payable
- Convert bonds payable into common stock
Required disclosure:
These transactions must be disclosed supplementally to the statement of cash flows even though they don't appear in the main body.
Three Required Supplemental Disclosures
Required when indirect method is used. Discloses actual cash paid for interest and income taxes during the period, since these don't appear separately in the indirect format.
A schedule of all significant investing and financing transactions that did not involve cash. Required so users can see the full picture of capital structure changes.
Disclosure of which short-term investments the company treats as cash equivalents. Necessary because companies have some flexibility in classification.
LO6: Cash Flow Ratios
Liquidity and capital adequacy using the statement of cash flows
OCFCL
Operating Cash Flow to Current Liabilities
Purpose: Measures the ability to liquidate current liabilities from operating cash flows
Higher is better. Rising trend is favorable. CVS Health showed steadily improving OCFCL and compared favorably to Rite Aid and Walgreens Boots.
OCFCX
Operating Cash Flow to Capital Expenditures
Purpose: Measures ability to fund capital investments from operations; assesses if a firm can replace and expand PP&E
Ratio > 1.0 is healthy — indicates operations generate enough cash to fund capital spending. CVS Health's ratio was well above 1.0.
FCF
Free Cash Flow
Purpose: Cash remaining after maintaining and expanding PP&E; available for debt repayment, dividends, acquisitions, or investment
Positive FCF = generating cash above maintenance needs. A key indicator of financial health and growth capacity.
Target Corporation Example
| Item | FY 2021 ($M) |
|---|---|
| Net earnings | $6,946 |
| Cash from operating activities | $8,625 |
| Capital expenditures | $(3,544) |
| Free Cash Flow (8,625 − 3,544) | $5,081 |
| Cash used in financing (dividends + buybacks + debt) | $(8,071) |
Target generated $8,625M from operations, spent $3,544M on capex, leaving $5,081M of free cash flow which it used primarily to return cash to shareholders via dividends and buybacks.
Revenue Recognition — The 5-Step Model
The income statement answers How profitable is the company? How did it achieve that profitability? Will it persist?It separates operating activities (primary transactions) from nonoperating activities. Revenue recognition is heavily scrutinized by the SEC because it is an important measure of customers' response to a company's offerings and can be subject to management manipulation.
Core Principle
"An entity should recognize revenue to depict transfers of goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services."
5-Step Revenue Recognition Process
| Step | Action | Key Detail |
|---|---|---|
| 1 | Identify the contract with a customer | Need not be a legal document — oral agreement is fine. Must create enforceable rights and obligations based on normal business practices. |
| 2 | Identify the performance obligations in the contract | Find distinct "deliverables" the company agrees to provide. Each PO must be capable of providing benefits on its own or with readily available resources. Becomes the 'unit of account.' |
| 3 | Determine the transaction price | Amount the seller expects to be entitled to when POs are fulfilled. Includes variable consideration (volume discounts, credits, bonuses, royalties). Requires management estimates. |
| 4 | Allocate the transaction price to performance obligations | Required if there are multiple POs. Allocate based on Stand-alone Selling Prices (SSPs). If SSPs aren't observable, they must be estimated. |
| 5 | Recognize revenue when (or as) the seller satisfies a performance obligation | PO is satisfied when customer obtains control — i.e., ability to direct use and obtain substantially all remaining benefits. May be over time or at a point in time. |
Contract Assets vs. Liabilities
- Contract liability (unearned/deferred revenue): seller receives payment before recognizing revenue
- Contract asset: seller recognizes revenue before being entitled to bill for payment
Example: Company A delivers 200 of 300 units but can't bill until all 300 are delivered → records a contract asset of $200,000
Consignment Sales
- Consignor retains ownership until the consignee sells the item
- Consignor records no sales revenue until inventory is sold by the consignee
- Consignee sells merchandise on behalf of the consignor
Future Deliverables & Bundled Sales
Customers often purchase products or services prior to delivery (digital subscriptions, season tickets, rental income). Amounts paid in advance are recognized as a contract liability — usually labeled unearned revenue or deferred revenue.
Journal Entry Example — $840 Annual Digital Subscription
| Event | Entry | Amount |
|---|---|---|
| Jan 1 — Receive $840 cash | Cash (+A) Unearned Revenue (+L) | $840 |
| Jan 31 — Recognize 1 month ($840 ÷ 12 = $70) | Unearned Revenue (–L) Revenue (+R, +SE) | $70 |
Bundled Sales
Two or more products/services sold under one agreement for a lump-sum price but treated as separate performance obligations. Common in software (software + training + maintenance + support bundled together).
GAAP requirement: Allocate the transaction price among performance obligations in proportion to their stand-alone selling prices (SSPs).
Long-Term Contracts
Key reporting issues: (1) Is the project a single PO or multiple? (2) What is the expected transaction price? (3) Are POs fulfilled over time or at a point in time?
Haskell Construction — $8M Library Contract (in thousands)
| Year | Cost Incurred | % Complete | Revenue (Over Time) | Revenue (Point in Time) | Expense | GP (Over Time) |
|---|---|---|---|---|---|---|
| 1 | $1,800 | 1,800/6,000 = 30% | $8,000 × 30% = $2,400 | $0 | $1,800 | $600 |
| 2 | $4,200 | 4,200/6,000 = 70% | $8,000 × 70% = $5,600 | $8,000 | $4,200 | $1,400 |
| Total | $6,000 | — | $8,000 | $8,000 | $6,000 | $2,000 |
Key takeaway: Total revenue ($8,000K) and total gross profit ($2,000K) are identical under both methods — the only difference is when revenue and gross profit are recognized. Fulfillment over time smooths income; fulfillment at a point in time defers all income to Year 2.
Uncollectible Accounts Receivable
AR is reported on the balance sheet at net realizable value (amount expected to collect). Amazon 2021: gross receivables $33,991M less allowance $1,100M = net $32,891M. GAAP requires companies to estimate uncollectible amounts in advance using an allowance for uncollectible accounts — a contra-asset.
Aging Analysis (GAAP — Preferred)
Categorize receivables by days outstanding; larger % for older accounts.
| Age | Balance | % Uncoll. | Est. Loss |
|---|---|---|---|
| Current | $41,000 | 1.0% | $410 |
| 1–60 days past due | $32,000 | 3.0% | $960 |
| 61–90 days past due | $16,500 | 4.5% | $743 |
| Over 90 days past due | $8,700 | 11.0% | $957 |
| Total | $98,200 | — | $3,070 |
Percentage of Sales (Not GAAP)
Applies one flat % to total sales. Easier but less accurate.
$156,000 × 2.3% = $3,588 estimated uncollectible
Assigns the same % to all sales — useful for forecasting but not acceptable under GAAP.
Pledging & Factoring
- Pledging: use AR as collateral for a loan; AR stays on BS, disclosed in notes
- Factoring: sell AR to a bank/financial institution; AR removed from BS if sold
Key Journal Entries
| Transaction | Debit | Credit | Amount |
|---|---|---|---|
| Record credit sales | Accounts Receivable (+A) | Sales Revenue (+R, +SE) | $560,000 |
| Estimate bad debt expense | Bad Debt Expense (+E, –SE) | Allowance for Uncollectible Accounts (+XA, –A) | $3,070 |
| Write off specific account | Allowance for Uncollectible Accounts (–XA, +A) | Accounts Receivable (–A) | $2,100 |
Write-off effect: AR decreases and Allowance decreases by the same amount → net realizable value is unchanged (still $95,130 before and after writing off $2,100). The write-off is NOT an expense — the expense was already recorded when bad debt was estimated.
Earnings management via allowance (cookie jar reserve):managers can overestimate bad debt expense in Year 1 (bigger expense, lower income) to "save" earnings for Year 2 where less bad debt is needed, making Year 2 income look better. The allowance account is controlled by management but reviewed by auditors; changes are discussed in the MD&A section of the 10-K.
Operating Performance Ratios
| Ratio | Formula | What It Measures | Microsoft Example |
|---|---|---|---|
| NOPAT | (Net income – Nonop. revenues + Nonop. expenses) × (1 – tax rate) | Operating profitability excluding nonoperating items | $44,281 – [$77 × (1 – 25%)] = $44,223M (FY2020) |
| RNOA | NOPAT ÷ Average Net Operating Assets | How well company performs relative to its core operating investment; like ROA but excludes nonoperating components | Compared across competitors (higher = better) |
| NOPM | NOPAT ÷ Sales Revenue | Overall operating profitability per dollar of sales | >30 cents per $1 of sales in 2019 & 2020 |
| ART (Accounts Receivable Turnover) | Sales Revenue ÷ Average Accounts Receivable | Investment in receivables required to generate $1 of sales; how quickly AR is collected | ~4.5× (2019), ~4.7× (2020) |
| ACP (Average Collection Period) | 365 ÷ ART or Average AR ÷ Average Daily Sales | How long, on average, it takes to collect outstanding receivables; also called Days Sales Outstanding | 78.5 days (FY2020) |
Insights on receivables: Slowing ART may indicate deteriorating collectibility, extended credit terms, or taking on longer-paying customers — may signal a need to increase the allowance. Higher ART (and lower ACP) is generally better, indicating faster collection and better asset utilization.
Earnings Management & Quality of Earnings
Earnings management occurs when management uses discretion to mask the underlying economic performance of a company. Quality of earnings describes the extent to which reported income reflects true underlying economic performance — often compromised by earnings management.
Two Motives
- Mislead financial statement users about performance to gain economic advantage
- Influence legal contracts that use accounting numbers to specify obligations and outcomes
Channel Stuffing
Company uses market power to induce customers to buy more than needed, typically just before period-end. Revenue can still be recognized if title has transferred — so it inflates reported revenue without violating GAAP, but misleads users about sustainable demand.
Common Earnings Management Tactics
| Tactic | Description |
|---|---|
| Transaction timing | Accelerate or delay transactions to shift revenues/expenses across periods. |
| Biased estimates | Overly optimistic or pessimistic estimates in accrual accounting (revenue recognition, depreciation useful lives, bad debts). |
| Income smoothing | Time gains or losses to maintain a steady, consistent improvement in income each year. |
| Big bath | Recognize large nonrecurring losses in a period already showing depressed income — clears the deck for better future results. |
| Mischaracterized arm's-length transactions | Disguise sales to related parties or seller-financed buyers as independent transactions to inflate income. Transfers to related entities should NOT be recorded until an actual arm's-length transaction occurs. |
| Cookie jar reserve | Overestimate bad debt expense in Year 1 to build a reserve; release it in Year 2 to boost profits. |
Nonrecurring Items — Appendix 6A
Separating recurring from nonrecurringitems matters for two reasons: (1) evaluating current performance vs. prior year requires only recurring amounts; (2) forecasting future income should exclude items that won't repeat.
Discontinued Operations
A separately identifiable business unit that the company has sold or plans to sell. Reported below income from continuing operations in the income statement (net of tax).
Income Statement Presentation:
- Income/loss on discontinued operations (net of tax) ..... $340,000
- Gain/loss on sale of the unit (net of tax) ....................... $43,000
Restructuring Charges
Significant reorganization of operations — does not involve selling a separately identifiable business unit. Included in income from continuing operations.
Examples of restructuring activities:
- Consolidating production facilities
- Reorganizing sales operations
- Outsourcing certain activities
- Discontinuing product lines within a business unit
Two components:
- Employee severance costs — estimated total cost of terminating/relocating employees
- Asset write-downs — write-down of long-term assets due to facility closure/relocation
LO1: Common-Size Financial Statements
Vertical and horizontal analysis for meaningful comparison
Vertical Analysis (Common-Size)
Converts financial statement items to percentage form to enable comparison across companies of different sizes and across accounts within one set of statements. Income statement items are expressed as a % of net sales; balance sheet items as a % of total assets.
Income Statement
Each line ÷ Net Sales Revenue. Shows what % of each revenue dollar goes to COGS, gross profit, operating expenses, net income, etc.
PepsiCo example: COGS = $31,797 / $70,372 = 45.2%
Balance Sheet
Each account ÷ Total Assets. Reveals capital structure — how much is funded by current vs. long-term assets, creditors vs. owners.
Horizontal Analysis
Examines changes over time — useful for spotting trends and predicting future performance.
Percent Change Formula
Example (PepsiCo): Revenue grew 4.8% in 2020 vs. 2019, while net income fell 2.4% — suggests rising costs.
Business Environment Context
Meaningful financial analysis requires understanding the broader business context: the company's industry, competitive position, life cycle stage, technology, regulation, and customer base. Numbers without context can mislead.
LO2: Return on Investment Metrics
ROE, ROA, and Return on Financial Leverage
Return metrics divide a measure of performance (income) by the average amount of investment (balance sheet). The key relationship is: ROE = ROA + ROFL.
ROE
Return on Equity
Primary summary measure of company performance. How much profit generated per dollar of shareholder investment.
PepsiCo 2020: $7,175 ÷ [($13,552 + $14,868)/2] = 50.5%
ROA
Return on Assets
Return from operating and investing activities, ignoring financing. Uses Earnings Without Interest (EWI = Net Income + Interest × (1 − tax rate)).
PepsiCo 2020: ($7,175 + $1,252×0.75) ÷ [($92,918+$78,547)/2] = 9.5%
ROFL
Return on Financial Leverage
Measures the effect of debt financing on ROE. Positive when ROA > interest rate (leverage boosts ROE); negative when ROA < interest rate.
PepsiCo 2020: 50.5% − 9.5% = 41.0%
Financial Leverage — When Does It Help?
When ROA > Interest Rate (good times)
Debt amplifies ROE above ROA → positive ROFL. Using 50% debt can turn a 10% ROA into a 16% ROE.
When ROA < Interest Rate (bad times)
Debt reduces ROE below ROA → negative ROFL. Financial leverage makes a bad year worse by adding interest costs.
LO3: Disaggregating ROA into PM and AT
ROA = Profit Margin × Asset Turnover
The Disaggregation Formula
Captures both profitability (how much profit per sales dollar) and efficiency (how many sales per asset dollar). There is often a trade-off between PM and AT — high-margin retailers tend to have lower turnover, and vice versa.
PM
Profit Margin
Profitability: measures pre-interest profit earned per sales dollar. Affected by gross profit level, operating expenses, competition, and pricing power.
Further split by: Gross Profit Margin (GPM) = (Sales − COGS) ÷ Sales; and Expense-to-Sales (ETS) = Expense ÷ Sales for any category
AT
Asset Turnover
Efficiency: measures sales generated per asset dollar. Improves by increasing sales or decreasing assets.
Further split by: Accounts Receivable Turnover (ART), Inventory Turnover (INVT), PP&E Turnover (PPET)
| Component | Formula | Measures |
|---|---|---|
| GPM | (Sales − COGS) ÷ Sales | % of each revenue dollar left after product costs |
| ETS | Expense ÷ Sales | % of revenue consumed by a specific expense |
| ART | Sales ÷ Avg. AR | Times receivables collected per year |
| INVT | COGS ÷ Avg. Inventory | Times inventory sold per year |
| PPET | Sales ÷ Avg. Net PP&E | Sales generated per dollar of fixed assets |
LO4: Liquidity and Solvency Analysis
Short-term cash availability and long-term debt obligations
Liquidity Ratios
Assess the ability to pay obligations coming due within the next year.
| Ratio | Formula | Notes |
|---|---|---|
| Current Ratio | Current Assets ÷ Current Liabilities | Relative magnitude of current assets vs liabilities. Working capital = CA − CL (positive implies more inflows than outflows short-term). |
| Quick Ratio | (Cash + Short-term Securities + AR) ÷ Current Liabilities | Excludes inventories and prepaids — reflects ability to meet CL without liquidating inventory (which may require markdowns). |
| OCFCL | Cash Flow from Operations ÷ Avg. Current Liabilities | Key factor in ultimate ability to pay debts — relates actual cash generated to payment obligations. |
| Cash Burn Rate | Free Cash Flow ÷ Days in Period | Used only when FCF is negative (young/distressed firms). Measures how fast cash is being consumed. |
Solvency Ratios
Assess the ability to meet long-term debt obligations — periodic interest payments and principal repayment.
Debt-to-Equity Ratio
Higher ratios = less solvency, more risk. Affected by asset mix and business stability. PepsiCo 2020: $79,366 / $13,552 = 5.9× (vs. retail avg of 1.31).
Times Interest Earned (TIE)
How much operating profit is available to cover interest. Lenders prefer a sufficiently high TIE to imply low default risk. PepsiCo 2020: ($9,069 + $1,252) / $1,252 = 8.2×.
Appendix 5A: Operating Activities & RNOA
Isolating operating performance from financing effects
Why Separate Operating from Financing?
Operating activities create the most persistent, long-lasting effects on future profitability. Separating them reveals whether ROE is driven by operations or by financial leverage decisions.
RNOA
Return on Net Operating Assets
Measures return generated by operating assets. Average public company derives most of its ROE from RNOA. = NOPM × NOAT.
NOPAT
Net Operating Profit After Taxes
Focuses only on operating performance. Nonoperating items (interest income, interest expense) are excluded using statutory tax rate.
NOA
Net Operating Assets
Operating assets: most current assets (excl. short-term investments) + most long-term assets (excl. investments). Operating liabilities: most CL (excl. notes payable, interest payable) + pension liabilities + deferred tax liabilities.
RNOA = NOPM × NOAT
Just like ROA = PM × AT, RNOA can be split into operating margin and operating asset efficiency:
NOPM = NOPAT ÷ Sales
Cents of operating profit per sales dollar (excl. financing). PepsiCo 2020: $7,933 / $70,372 = 11.3%
NOAT = Sales ÷ Avg. NOA
Sales per dollar of net operating assets. PepsiCo 2020: $70,372 / $51,083 = 1.38×
Appendix 5B: Financial Statement Forecasts
Seven-step process for preparing pro forma statements
Forecast statements are hypothetical — prepared to reflect specific assumptions about future transactions. The goal is accuracy, not precision; sensitivity analysis helps examine the effect of different assumptions.
| Step | Action | Method |
|---|---|---|
| 1 | Forecast Sales Revenue | Start with historical growth rate (horizontal analysis). Forecasted revenue = Current revenue × (1 + growth rate). |
| 2 | Forecast Operating Expenses | Use common-size income statement ratios (ETS). Forecasted expense = Forecasted revenue × ETS ratio. |
| 3 | Forecast Operating Assets & Liabilities | Use asset turnover relationships. Forecasted AR = (Reported AR / Reported Sales) × Forecasted Sales. Same for other operating assets/liabilities. |
| 4 | Forecast Nonoperating Items | Starting point: assume no change from current amounts. Adjust based on notes or MD&A disclosures. |
| 5 | Forecast Net Income, Dividends & Retained Earnings | Tax: Forecasted pretax income × Effective tax rate. Dividends: Net income × dividend payout ratio. RE: Begin RE + Net Income − Dividends. |
| 6 | Forecast Cash (plug) | Makes the balance sheet balance. If negative/unreasonable, adjust short-term borrowing or marketable securities and cascade changes through taxes and retained earnings. |
| 7 | Prepare Cash Flow Statement | Derived from forecasted income statement and balance sheet changes. Forecast depreciation if not already in operating expenses. |
LO1: Reporting Inventories
Expense recognition, inventory types, and disclosure requirements
Three Expense Recognition Approaches
Direct Association
Costs directly tied to a specific revenue source. Recognized when the related revenue is recognized.
Examples: Cost of goods sold, warranty costs
Immediate Recognition
Costs associated with a period but not with any specific transaction. Recognized when incurred.
Examples: Admin costs (insurance, utilities, salaries), marketing, R&D
Systematic Allocation
Costs benefiting multiple periods, not linked to specific revenues. Capitalized as asset, expensed over useful life.
Examples: Depreciation expense
What is Included in Inventory Cost?
Inventory is reported at cost, which includes: cost to acquire + transportation + preparation costs + consideration of volume/cash discounts.
Legal Title Rules
- FOB Shipping Point: Buyer gets title when shipped — buyer records inventory immediately upon shipment
- Goods in transit: Seller retains in inventory until revenue recognition requirements are met
- Consignment: Goods held by distributor remain in the seller's inventory until sold to end customer
Inventory Types for Manufacturers
Raw Materials
Parts and materials purchased from suppliers for use in production
Work-in-Process (WIP)
Partially completed goods; includes materials, labor, and overhead costs
Finished Goods
Completed products ready for delivery to customers
LO2: Inventory Costing Methods
FIFO, LIFO, and Average Cost — how costs flow to COGS and ending inventory
When inventory is sold, its cost must be transferred to COGS. Physical inventory flow need not match the cost flow assumption. Beginning inventory + Purchases = Cost of Goods Available for Sale → split between COGS and Ending Inventory.
FIFO
First-In, First-Out
Rule:
Oldest costs transferred to COGS first
In rising prices:
Higher COGS ← Lower (oldest costs) → Higher ending inventory; Higher gross profit; Higher taxes
LIFO
Last-In, First-Out
Rule:
Most recent costs transferred to COGS first
In rising prices:
Lower COGS ← Higher (newest costs) → Lower ending inventory; Lower gross profit; Lower taxes (tax benefit); Not allowed under IFRS
AC
Average Cost
Rule:
Weighted average of all units available for sale
In rising prices:
Results fall between FIFO and LIFO; Average cost = Total cost ÷ Total units available
Phelps Inc. Example (Goggles — June)
Beginning: 100 @ $4.00. Purchased: 400 @ $4.50. Sold: 460 @ $12.00. Total available: $2,200.
| Method | COGS | Ending Inv. | Calculation |
|---|---|---|---|
| FIFO | $2,020 | $180 (40 @ $4.50) | 100@$4 + 360@$4.50 to COGS |
| LIFO | $2,040 | $160 (40 @ $4.00) | 400@$4.50 + 60@$4.00 to COGS |
| Avg Cost | $2,024 | $176 (40 @ $4.40) | Avg = $4.40; 460 × $4.40 |
LO3: Lower of Cost or Net Realizable Value (LCNRV)
Conservatism in inventory valuation
When NRV < Cost → Write-Down Required
- Inventory book value written down to NRV (reduces total assets)
- Write-down recorded as expense on income statement (included in COGS)
- Reduces current period gross profit, net income, and equity
When NRV ≥ Cost → No Change
- Inventory remains on balance sheet at historical cost
- No write-down is required
NRV = estimated selling price − costs to complete/sell
IFRS Difference
Under IFRS, inventory write-downs can be reversed if market value later increases — up to the original acquisition cost. Under US GAAP, reversals are not permitted.
Why Disclosures Matter
- Inventory is often the largest asset for manufacturers and merchandisers
- Risk of loss is high (obsolescence, changing consumer tastes)
- High inventory levels create storage, financing, and insurance costs
- Level of inventory is a leading indicator of future performance (good and bad)
LO4: Effects of Inventory Costing on Financial Statements
Management decisions and comparability across methods
Summary of Method Effects (Rising Prices)
| Effect | FIFO | LIFO | Avg Cost |
|---|---|---|---|
| COGS | Lowest | Highest | Middle |
| Gross Profit & Net Income | Highest | Lowest | Middle |
| Ending Inventory (B/S) | Closest to current value | Understated | Middle |
| Income Taxes | Highest | Lowest (tax benefit) | Middle |
| Cash Flow from taxes | Less cash | More cash | Middle |
LIFO Reserve
The difference between LIFO cost and current value of inventory. Must be disclosed by LIFO companies. Used to convert LIFO to FIFO for comparisons:
FIFO Inventory = LIFO Inventory + LIFO Reserve
FIFO COGS = LIFO COGS − Change in LIFO Reserve
IFRS Note
LIFO is not allowed under IFRS. This creates comparability challenges: analysts tracking FIFO firms vs. LIFO firms must adjust, and switching from LIFO to FIFO would trigger significant tax payments on deferred inventory gains.
LO5: Gross Profit Margin & Inventory Turnover
Ratio analysis for inventory quality and asset utilization
Gross Profit Margin (GPM)
% of each revenue dollar remaining after product costs. Closely monitored by management and investors.
Causes of declining GPM:
- Stale product line
- Change in product mix
- New competition
- General economic decline
- Inventory overstocking
Inventory Turnover
How many times inventory is sold per year. Higher = better (faster selling, fresher stock). Adjust to FIFO basis when comparing LIFO and FIFO firms.
Avg. Inventory Days Outstanding
How long items sit in inventory before being sold. Lower is better. Home Depot ~71 days in 2020.
Optimizing Inventory
Too much inventory:
- Financing costs to purchase
- Storage, handling, and insurance costs
- Risk of obsolescence
Too little inventory:
- Stock-outs and lost sales
- Damage to customer relationships
- Operational disruptions
Solutions: JIT deliveries, demand-pull production, improved manufacturing processes.
Appendix 7A: LIFO Liquidations
When old LIFO layers are dipped into — earnings boost and tax implications
What Is a LIFO Liquidation?
Occurs when a LIFO firm sells more inventory than it purchases, forcing it to dip into older, lower-cost layers. The old (lower) costs flow to COGS instead of current (higher) costs → artificially boosts gross profit. Companies must disclose the LIFO liquidation gain in footnotes.
Why Liquidations Happen
Involuntary:
- Supply disruptions (natural disasters, strikes)
- Production shutdowns
Intentional:
- Efforts to reduce costs or improve efficiency
- Earnings management — boosting reported profit
Conflicting Incentives
Tax incentive: Avoid liquidation
LIFO firms defer taxes by keeping old layers intact. A liquidation accelerates tax payments by recognizing old, low-cost inventory.
Financial reporting incentive: Create liquidation
Matching old costs against current prices boosts gross profit, which may be used for earnings management.
LO1: Capitalize vs. Expense Costs
Long-term operating assets, capitalized costs, and subsequent expenditures
Long-Term Operating Assets
Assets acquired to produce and deliver products/services that generate revenues over multiple periods.
Tangible Assets (PP&E)
Have physical substance. Land, buildings, machinery, fixtures, and equipment.
Intangible Assets
No physical substance. Provide owner with specific rights and privileges. Trademarks, patents, copyrights.
Capitalized Costs
Rule: All costs necessary to acquire an asset and prepare it for its intended use are capitalized.
- Installation costs, taxes, shipping costs
- Legal fees, setup and calibration costs
- Asset retirement obligations
Three Requirements to Capitalize
- Asset must be owned or controlled by the company.
- Asset must be expected to provide future benefits.
- Capitalized costs cannot exceed expected future benefits.
Constructed Assets
When assets are built by the company for its own use, capitalize:
- All direct material and labor costs
- A reasonable amount of overhead costs
- Capitalized interest — interest on debt financing the construction (only if specific criteria are met)
Costs Subsequent to Acquisition
Capitalize (Improvement / Betterment)
Outlays that enhance usefulness or extend useful life beyond original expectation. Added to asset's book value.
Expense (Routine Repairs)
Routine repairs and maintenance are expensed in the period incurred. Do not extend useful life.
LO2: Depreciation Methods
Allocating PP&E cost over useful life — straight-line, DDB, and units-of-production
What Is Depreciation?
A systematic allocation of the cost of a PP&E asset to expense over the period it helps produce revenue. Cost transfers from the balance sheet to the income statement. Depreciation is an allocation, not a valuation.
Two Key Estimates
Useful Life
Period the asset is expected to provide economic benefits. Differs from physical life.
Residual Value (Salvage Value)
Expected realizable value at end of useful life. Scrap, disposal, or resale value.
Depreciable Base = Cost − Residual Value. All three methods allocate this same nonrecoverable cost.
Three Depreciation Methods
Example: Truck cost $80,000 | Residual $8,000 | Useful life 5 years
| Method | Formula | Year 1 Expense | Pattern |
|---|---|---|---|
| Straight-Line (SL) | (Cost − Residual) × 1/Life = $72,000 × 20% | $14,400 | Equal each year |
| Double-Declining-Balance (DDB) | Book Value × (2 × SL rate) = $80,000 × 40% | $32,000 | More in early years (accelerated) |
| Units-of-Production (UOP) | (Cost − Residual) ÷ Total Units × Actual Units = $0.90/mi × 18,000 mi | $16,200 | Varies with activity |
Balance Sheet Presentation
Delivery truck, at cost $80,000
Less accumulated depreciation (12,000)
Delivery truck, net $68,000
Accumulated Depreciation is a contra-asset account. Book Value = Cost − Accumulated Depreciation.
Changes in Accounting Estimates
When useful life or residual value estimates change, the change is applied prospectively (only future periods).
Steps to Recalculate Depreciation
- Find book value at date of estimate change (Cost − Accum. Depr.)
- Determine new remaining useful life = Original − Years used + Additional years
- New annual depreciation = (Book value − Residual) ÷ New remaining life
LO3: Asset Sales and Impairments
Gains/losses on disposal and recognizing permanent declines in value
Gains and Losses on Asset Sales
Gain on Sale
Proceeds > Book Value → Gain recognized on income statement.
Loss on Sale
Proceeds < Book Value → Loss recognized on income statement.
Journal Entry to Record Asset Sale
- Remove asset cost (credit the asset account)
- Remove accumulated depreciation (debit accumulated depreciation)
- Record cash proceeds (debit cash)
- Record gain (credit) or loss (debit) on income statement
Example: Truck cost $80,000, accum. depr. $57,600 (4 yrs SL), sold for $25,000 → Book Value $22,400 → Gain $2,600
Asset Impairments
Companies must recognize losses when long-term assets are permanently impaired (market value declines below book value).
Two Challenges
Insufficient Write-Down:
Assets sometimes impaired more than recognized.
"Big Bath" Scenario:
Aggressive write-down when income is severely depressed — frontloads losses.
IFRS vs. GAAP (Impairment)
GAAP (US): Two-step test. Write-down = Book Value − Fair Value.
IFRS: Single-step. Compare to recoverable amount (higher of fair value or value-in-use). Assets can be revalued upward if fair value is reliably measurable.
LO4: PPE Ratios and Cash Flow Effects
PPE Turnover, Percent Depreciated, and investing cash flows
PPE Turnover (PPET)
Measures management efficiency in using plant assets. Higher = better. Differs widely by industry — capital-intensive industries (airlines, telecom) have lower PPET.
Percent Depreciated
Measures what fraction of operating assets have been depreciated. Mature companies typically show ~50–60%. Higher % = older asset base.
Cash Flow Effects (Investing Section)
- Acquisition of PP&E → Use of cash (outflow)
- Proceeds from asset sales → Source of cash (inflow)
- Stock dividends, stock splits, and depreciation itself have no direct cash effect
LO5: Intangible Assets
Patents, copyrights, trademarks, franchise rights, goodwill, and amortization
Separately Transferable
Contractually/legally defined OR can be separated and sold. Includes patents, copyrights, trademarks, franchise rights.
Not Separately Transferable (Goodwill)
Excess of purchase price over fair value of net assets acquired. Cannot be sold separately from the company.
Common Intangibles
| Type | Definition | Accounting |
|---|---|---|
| Patent | Exclusive right to produce a product or use a technology | Purchased: capitalize & amortize. Internally developed: only legal/registration fees capitalized. |
| Copyright | Exclusive right for creator + 70 years | Capitalize purchase cost; amortize over expected economic life. |
| Trademark | Registered name, logo, jingle, or slogan | Purchased: capitalize & amortize. Internally developed (incl. advertising): expense as incurred. |
| Franchise Right | Right to operate a business in an area for a period | Capitalize start-up costs and franchise fees; amortize over term. |
| Goodwill | Excess purchase price over fair value of net assets acquired | Never amortized. Tested annually for impairment. |
| Digital Assets (e.g. Bitcoin) | Indefinite-lived intangible (not cash or financial security) | Recorded at cost; subject to impairment testing (write down, never up under GAAP). |
Amortization Rules
Definite Life
Amortize over expected useful life (straight-line most common). Expense reported in SG&A on income statement.
Example: $80,000 patent with 5-year useful life → $16,000/year amortization.
Indefinite Life
Not amortized until useful life can be specified. Tested for impairment annually. Write-down = Book Value − Fair Value.
LO6: Analysis Implications of Intangibles
Hidden intangibles and how they distort financial ratios
Hidden Intangible Assets
Internally generated intangibles (R&D, brand building, employee training) are not capitalized under GAAP — they are expensed immediately. This creates a systematic understatement of assets for innovation-heavy firms.
- Uncapitalized assets do not appear on financial statements.
- Creates upward bias in asset turnover ratios and ROE.
- Makes cross-company comparisons difficult for analysts.
- Alternative: compare R&D expense as a % of sales across firms.
LO1: Stock Issuances and Repurchases
Contributed capital, par value, common vs. preferred stock, treasury stock
Stockholders' Equity Components
Contributed Capital
Cumulative cash from stock issuances minus net cash paid to repurchase own stock. Includes:
- Common stock (at par value)
- Preferred stock (at par value)
- Additional paid-in capital (APIC)
Earned Capital
Cumulative net income retained by the company. Includes:
- Retained earnings
- Accumulated other comprehensive income (AOCI)
Share Counts
| Term | Definition |
|---|---|
| Authorized Shares | Upper limit set in corporate charter; can be increased by shareholder vote. |
| Issued Shares | Actual shares issued to shareholders to date. |
| Outstanding Shares | Issued shares minus treasury shares repurchased by the company. |
Common vs. Preferred Stock
Common Stock
- Primary ownership unit; carries voting rights
- Par value is an arbitrary nominal value in the corporate charter
- Issuance → Common Stock (par × shares) + APIC (remainder)
- First issuance = IPO (Initial Public Offering)
Preferred Stock
- Dividend preference: receives dividends before common
- Liquidation preference: paid before common in liquidation
- Optional: callable, convertible, or participating features
Treasury Stock Repurchases
Why Companies Repurchase Stock
- Reduce shares outstanding → potentially boost EPS and share price
- Signal that management believes stock is undervalued
- Offset dilution from employee stock option programs
Accounting for Treasury Stock
- No gain or loss on the income statement from repurchases or reissues
- Treasury stock is a contra stockholders' equity account (deducted from total equity)
- Difference between cost and resale price is an adjustment to APIC
LO2: Earnings, Dividends, and Stock Splits
Retained earnings, cash dividends, cumulative preferred, stock dividends, and splits
Retained Earnings Changes
- Increased by: net income
- Decreased by: net losses, cash dividends, property dividends, stock dividends
- AOCI changes (foreign currency, unrealized gains/losses, pension adjustments) are separate from retained earnings
Cash Dividends
Most dividends are paid in cash, usually quarterly. Dividend payments have no effect on net income.
Cumulative Preferred Stock
Unpaid prior-year dividends (dividends in arrears) must be paid to preferred shareholders before any common dividends are declared. Non-cumulative preferred loses unpaid dividends permanently.
Stock Dividends vs. Stock Splits
| Feature | Small Stock Dividend (<20–25%) | Large Stock Dividend (>20–25%) | Stock Split |
|---|---|---|---|
| Retained Earnings reduced by | Market value of shares distributed | Par value of shares distributed | No effect |
| Contributed Capital | Increases by market value | Increases by par value | Par value per share decreases |
| Net stockholders' equity | No change | No change | No change |
| Cash effect | None | None | None |
Stock dividends and splits have no effect on each investor's ownership percentage or total stockholders' equity.
LO3: Comprehensive Income
Net income plus AOCI items outside management's direct control
Comprehensive Income = Net Income + Other Comprehensive Income (OCI)
A more inclusive measure of company performance than net income. Includes all recognized equity changes except exchanges with owners (dividends, stock issuances).
- Foreign currency translation adjustments
- Unrealized gains/losses on available-for-sale debt securities and derivatives
- Certain pension and other benefit plan adjustments
Retained Earnings
Closed to retained earnings at year-end. Represents profits/losses under management's control.
AOCI (Accumulated OCI)
OCI items are not closed to retained earnings. Closed to a separate equity account: AOCI. Represents items considered outside management's control.
LO4: Earnings Per Share (EPS)
Basic EPS, Diluted EPS, and the complex capital structure
Basic EPS (BEPS)
Always required. Preferred dividends subtracted because EPS measures income available to common shareholders.
Diluted EPS (DEPS)
Required when company has a complex capital structure (dilutive securities outstanding). DEPS ≤ BEPS.
Dilutive Securities (Complex Capital Structure)
- Stock options — right to purchase shares at a fixed price
- Convertible debt — bonds that can be exchanged for common stock
- Convertible preferred stock — preferred shares that convert to common
Analysts focus more on diluted EPS because it reflects potential dilution and is more conservative.
Return on Common Equity (ROCE)
Similar to ROE but removes the effect of preferred stock and noncontrolling interests. More accurate measure of return to common shareholders when preferred stock is present.
Book Value Per Share
Net book value available to common shareholders per share.
Appendix 11A: Convertible Securities, Stock Options, and Restricted Stock
Convertible debt/preferred, stock warrants, ESOs, RSAs, and RSUs
Convertible Securities
Convertible Debt
Holder can convert bonds into a predetermined number of common shares. Recorded as a single debt instrument under GAAP. Upon conversion: remove debt book value, increase contributed capital.
Convertible Preferred Stock
Preferred shareholders convert shares into common at a predetermined ratio. Remove preferred stock, increase common stock and APIC upon conversion.
IFRS difference: Convertible securities are "compound financial instruments" — split between debt and equity components at issuance.
Stock Rights (Warrants)
Give the holder an option to acquire shares at a specified price within a stated period. Evidenced by a stock warrant certificate. Issued to compensate outsiders, give shareholders preemptive rights, or enhance marketability of other securities.
Employee Stock Options (ESOs)
- Give employees the right to buy shares at a fixed price in the future
- Vesting period: employee cannot exercise options until vesting completes
- Fair value of each option grant must be recognized as compensation expense over the vesting period
- Example: 8,000 options at $12 fair value, 4-year vest → $24,000 expense per year
Restricted Stock Awards (RSAs) and Units (RSUs)
RSAs
Shares granted immediately but rights restricted until vesting. Entry on grant date: debit Unearned Compensation, credit Common Stock + APIC. Compensation expense recognized over vesting period.
RSUs
Promise to transfer shares — no actual shares granted until vesting completes. No entry on grant date. Compensation expense each year → Paid-in capital-Restricted stock. At vesting, reclassify to Common Stock + APIC.