ACC 500 - Financial Accounting

Studying for the Final - Part 3

noreply@blogger.com (Eliezer) — Thu, 20 Nov 2008 14:53:00 +0000

Journal Entries to Know:

Ch 8
Separately Stated Interest
Dividends at declaration, record and payment dates
Recording and payment of wages
Payroll Taxes and Benefits
Estimated Income Taxes
Product Warranties
Contingent Liabilities

Ch 9
Initial purchase of a long-term asset
Depreciation of a Long-Term Asset
Ordinary repair and maintenance of long-term assets
Extraordinary repair that extends useful life of assets
Additions and betterments of long-term assets
Sale/disposal of an asset at a loss
Sale of an asset at a gain

Ch 10
Bond issued at face value
Payment of bond interest
Bond issued at a discount
Bond issues at a premium
Amortization of bond discount
Retirement of bond issued at a premium with loss/gain on retirement
Retirement of bond issued at a discount with loss/gain on retirement
Conversion of bond issued at a premium
Conversion of bond issued at a discount
On signing a long-term lease
Lease payments
Estimated Pension Liabilities
Funding of Pension Liabilities
Estimated Post-Retirement Benefits
Funding of Post-Retirement Benefits

Studying for the Final - Part 2

noreply@blogger.com (Eliezer) — Thu, 20 Nov 2008 13:09:00 +0000

Multi-Step Income Statement

Know what to subtract from each item to get from..

Net Sales
to
Gross Margin
to
Operating Income
to
Net Income Before Taxes
to
Net Income

Studying for the Final - Part 1

noreply@blogger.com (Eliezer) — Thu, 20 Nov 2008 13:05:00 +0000

There's a lot of material for this exam. Here are the figures and ratios that I'm reviewing:

Working Capital
Current Ratio

Receivables Turnover
Days in Receivables

Inventory Turnover
Days in Inventory

Profit Margin
Asset Turnover
Return on Assets
Return on Equity

Debt to Equity
Interest Coverage

Free Cash Flow
EBIT
EBITDA

Price/Earnings Ratio
Dividend Yield

Lecture 10 - Income and Equity Statements

noreply@blogger.com (Eliezer) — Thu, 13 Nov 2008 23:53:00 +0000

Income and Equity Statements

Quality of Earnings

Everyone looks at the bottom line.

If everyone has the same bottom line (net income), are they equivalent - comparable quality of earnings?

All-inclusive concept requires extraordinary items to be included. However, this can pump up earnings artificially. To the extent that income is attributable to continued operating income, it shows a higher quality of earnings.
Another example: Income from discontinued operations.
See page 613 for examples.

Income Taxes

Depreciation may be different between financial accounting and tax accounting. (Straight line for FA and accelerated for TA)

To resolve this problem, use interperiod income tax allocation. See example in class slides.

To adjust in the first year...
Dr. Provision for taxes 200
--- Cr. Tax Liability 120
--- Cr. Deferred Taxes 80

In the following year...
Dr. Provision for Income Tax 200
Dr. Deferred Taxes 80 (eliminate the previous years' credit)
--- Cr. Tax Liability 280

Discontinued Operations

Notify analysts that some of income is from operations that are no longer going on.
Report the Income from these ops and the gain/loss on disposition of assets.

Ordinary income is the income from continuing operations.

Separate the reporting of the income tax expense from ordinary and taxes from discontinued ops. This is intraperiod income tax allocation.

See example in class slides (pg. 9-15)

Extraordinary Items

Separately disclosed so the reader knows it's not likely to continue. Exact definition is not clear. Standard definition is that it's "extraordinary" if it's "the result of an unusual event and infrequent."

Presented just like discontinued operations and net of tax.

All such income is presented before net income.

Earnings Per Share

Was formerly a very difficult topic on the CPA exam.

It's for common shares only. Subtract out those earnings that are attributable to preferred shares - dividends.

Compute for each component:
Operating income per share
Extraordinary items per share
Discon
Net income

Must use a weighted average of shares outstanding throughout the year, not the simplified average that we use with some of the ratios.

Options or other securities that could be converted to common stock are “dilutive” and result in a lower earnings per share. Do an additional calculation based on an assumption that those securities get converted to get a diluted eps. Converting bonds will increase the denominator (# of shares outstanding) but may also increase the numerator also because there will be less interest to pay on those bonds.

Statement of Stockholders’ Equity

The details of this statement are not material for the exam. But there is usually a statement of stockholders’ equity, not just retained earning.

This statement will have information on common stock, preferred stock and other capital accounts in addition to retained earnings.

Unrealized gain/loss on available for sale securities and foreign currency conversion adjustments were once reported in the statement of shareholders’ equity. FASB then required them to appear on the balance sheet and to report “comprehensive income” Some companies start with net income and add items to get to comprehensive income. Apple embeds it in the calculation of net income.

Stock Dividend

Issuance of addition stock as a dividend. These have the advantage that they are not taxable to the shareholders and if they need the cash, they can always sell it.

Note: We’re not covering entries on declaration, record and distribution dates.

Stock Split

Cancels old shares and issues 2x new shares. Why? Makes the shares more affordable for investors.

There are also occasionally reverse splits. Why? Because shares could be delisted if the share price is too low.

No entries are required for stock splits.

Book Value (or Book Value per Share)

Equity attributable to common shares of stock
Equity attributable to

Ex:
Assets 2,000,000
Liabilities 1,000,000
Owner’s Equity 1,000,000

1,000,000 shares of common stock outstanding

Book value is 1,000,000
Book value per share is $1.00

Ex 2:
Say there was 200,000 common share and 800,000 preferred
Book value per share is $0.80

Ex 3: If preferred stock was callable at 102, reduce the
1,000,000 – 1.02(200,000) / 1,000,000

How valuable is this number? It doesn’t mean that much, it’s hard to interpret. Nonetheless, people give it attention “we paid 5x book value”.

Cash Flow Statement

Required in order to give audited statement. Hard to derive information from other statements. Possible, but difficult.

Focus is on the change in cash balances. If you just look at the bottom line, it’ll be hard to interpret what impacted the cash flow. The source is more important than the amount.

Explains the net increase/decrease in cash by explaining the cash flow from:
Operating activities
Investing activities – of the firm itself. Firm sold some assets to generate cash
Financing activities – raising cash from debt or equity

Some things that are done directly are prepared on separate schedule (ex: issuing shares to purchase a building, if done in one transaction.)

Two methods: direct and indirect. Book only covers indirect (formerly covered both), and we will only cover it also.

Indirect method: Starts with net income and adjusts it to convert to cash flows from operations.

How do we get there?

We assume that net income is a first approximation of cash flow. But some things are not and we need to adjust for those.

On the revenue side, Ex: accounts receivable. It increases the AR asset account but doesn’t affect the Cash account.

So we subtract out any increases in current assets.

We must also subtract out any decreases in current liabilities

On the expense side,
We must add in the increases in current liabilities and…
Add back in the decreases in current assets

How do we handle depreciation and other non-cash expenses? They are expenses that do not involve real cash flows. So add it back in to the net income.

How do we handle gains and losses?
Typically, the entry for the sale of an asset is…
Dr. Cash
Dr. Accum Depr
Cr. Asset
Cr. Gain

Gain shows up in the income statement. But we don’t want that gain in the cash flow. We’re interested in the Cash amount. So deduct any gains and add in any losses.

Some ppl talk about the “cash flow generated from depreciation”. Although it’s a positive number that is added to net income, it’s really not accurate to call it a cash flow. It’s an adjustment.

Cash flow from Investing Activities and Sale of Plant Assets

See examples in class slides.

Lecture 9 - Contributed Capital

noreply@blogger.com (Eliezer) — Fri, 07 Nov 2008 16:35:00 +0000

Contributed Capital

This only applies to corporations. Sole proprietorship and partnerships are easier.

Limited liability is a benefit – owner is not personally liable, encourages risk-taking, easier to raise capital by selling stock

Lack of mutual agency – in a partnership, one of the partners can obligate the partnership. In a corporation, only officers of the corporation can.

Death of a corporate owner (shareholder) does not affect the corporation.

Disadvantages include govt regulation, taxation, limited liability (may not be able to raise capital from banks due to limited liability) and separation of ownership and control (mgmt may not do what shareholders want).

Ratio Analysis

Dividend Yield = dividends per share / market price per share

Use this to compare to bank interest rate or bonds. Even if it’s less, may be ok due to appreciation of share price.

P/E Ratio = price per share / earnings per share

ROE shows how effectively company is using its assets.
ROE = net income / avg stockholders equity
ROE can be manipulated

Terminology:
Common stock par value
Common stock excess over par

Ex: issuing 100 shares at $18/share with $10 par value per share
Par value 1000
Excess over par 800

Some states have statues against paying dividends from par value.

Some financial statements don’t have a par value (if not required by the state).
Preferred stock

Always has a par value and it’s relevant. It’s an expected dividend. In some sense similar to a bond.

Its dividends are preferred before common stock holders get theirs.

Preferred stock can be non-cumulative and the amounts skipped in prior years are just gone. They can also be cumulative

Convertible preferred shares

Can be convertible from preferred to common shares

Callable preferred stock

Allows the company to buy back the preferred stock.

Treasury stock

Company buys back its stock and puts it in its “treasury”
Issued-treasury = outstanding
Why buy back?
Prevents hostile takeover
To boost earnings per share

Dr. Treasury stock
--- Cr. Cash

Shows up as a reduction of owners equity

On resale of treasury stock, no gain or loss is recognized on the purchase or sale of treasury stock.

Compensatory Stock Options

Usually issued at current market price.

Revised Fasb 123 deals with this. Either record it or put it in the footnotes. They chose to put it in footnotes, of course.

This hiding of compensation expenses and the motivating of officers to manipulate income contributed to the collapse of Enron.

Lecture 9 - Long-Term Leases and Pension Obligations

noreply@blogger.com (Eliezer) — Fri, 07 Nov 2008 16:33:00 +0000

Long-Term Leases

Leases are similar to borrowing money. Sometimes you have to record it in the same way.

Usually, there’s nothing on the books when you sign the lease. Then record the lease expenses as incurred.

If it’s a big capital lease, like an airplane, and the lease covers the length of the useful life (ex. 20 years), you may be required to record it as if you purchased it:
Dr. Leased Equipment
--- Cr. Lease Obligation

When you make a lease payment,
Dr. Lease Obligation
Dr. Interest expense
--- Cr. Cash

We won’t go through how you make the calculations for the amounts of the lease obligation and the interest.

At the end of the year, depreciate it:
Dr. Depreciation expense leased equipment
--- Cr. Accumulated depreciation on leased equipment

Guidelines and criteria for using capital leasing approach
- how much of the useful life of the asset does the lease cover
- do you have the option to purchase the underlying property at a low rate

Pension Obligations

Defined contribution vs. Defined benefit plan (per ERISA)

Defined benefit plan – employer says to employee: after you retire, assuming you’ve been with the firm for 20 year, we’ll pay you a retirement benefit of 80% of the highest salary you received with the firm. Employer bears the risk of adverse investments. PBGC (pension benefit guarantee corp) guarantees/insures the pension fund.

Defined contribution plan – you and the employer or both (optionally) make contributions to a fund (some tax benefits). When you retire, you can take those funds as a lump sum or an annuity. Employee bears the risk of adverse investment yield. No long term liability for the firm. No need for special accounting.

With Defined benefit plans we need special accounting for the firm’s liability. You must estimate the retirement cost of current employees incurred this year (via actuarial methods).
Dr. Pension Expense
--- Cr. Liability for pensions
Dr. Pension Liability
--- Cr. Cash

If this balances out, you’ll have zero net liability. That would be a “fully funded” pension plan. If not, it’s unfunded pension liability.

Many companies are going from defined benefit plans to defined contribution plans.

Another type of expense on the books that should be recorded today rather than when it’s paid out later – medical expenses to be covered after retirement. Year’s ago, it wasn’t on the books until it was incurred. Now, it’s accounted for like pension plans.
Dr. Post Ret. Med Expense
--- Cr. Liability for Post Ret. Exp
Dr. Liability for Post Ret. Exp
--- Cr. Cash

These expenses can be hugely significant. Many companies canceled/discontinued these plans.

Lecture 9 - Bonds (cont.)

noreply@blogger.com (Eliezer) — Fri, 07 Nov 2008 00:00:00 +0000

Amortizing the Discount

Over some period of time, you need to get the discount down to zero. You go thru the process at each payment date. Credit to Cash the amount that you have to pay out (interest rate x face value). Credit the Discount also to reduce it.

Interest Expense as a percentage of the carry value of the bond will be greater than the interest rate on the bond since it has to be the sum of the amount creditted to Cash (the interest amount) plus the amount of the discount being amortized.

Example:
Bond face value is 1,000,000
interest rate 5% per year
term = 20 years
interest is paid semi annually

Calculations:
cash payment is 5% of 1,000,000 = 50,000 per year. for half a year, it's 25,000. therefore, credit Cash 25,000. discount is 100,000. amortize over 40 payment periods - 2,500 per period. therefore, credit Discount 2,500. and the Debit Interest Expense 25,000+2,500 = 27,500.

Journal Entries:
Dr. Interest Expense 27,500
--- Cr. Discount 2,500
--- Cr. Cash 25,000

Bonds Bought/Sold between Interest Payment Dates

You're not entitled to the entire next interest payment. Issuing company just pays the full amount to the bond holder at the end of the period. The buyer pays the cost of the bond plus the accrued interest until the time of the sale. (Not covering calculations in detail.)

Retirement of Bonds

The issuing company may call back bonds. This usually happens when the market rate for the bond is going down because interest rates are going down. These are called "Callable Bonds". Even if a bond is not callable, the company may buy them back on the open market.

Getting the bond back

Retirement of Bonds

If interest rates go down and you decide to purchase on the open market one set of bonds and issue a new set at a lower rate, are you likely to recognize a loss on early retirement of the bond.

Even though this incurs a loss, in the long run it may well be in the best interest of the company to redeem the bonds and reissue at a lower rate.

Conversion of Bonds

This refers to converting bonds into stock.

Ex: bond issue is $1,000,000. 1000 bonds worth $1000 each. Each bond is convertible into 40 shares of common stock. Common Stock is selling at $15/share. Converting at this point is not a good idea since it would only bring in $600.

But in the long run, the ability to convert is valuable in case common stock goes up. This is known as an “equity kicker”. As a buyer, you may be willing to pay more for a convertible bond, i.e. be willing to accept a lower interest rate.

If later the stock price is $30. Then, it would be in your interest to convert. This could be good for the company as well.

Journal entries to move bond entries to equity accounts
Dr. Bonds Payable
Dr. Premium (either/or)
Cr. Discount (either/or)
Cr. Common Stock
Cr. Additional PIC (paid-in capital)

Lecture 8 - Bonds

noreply@blogger.com (Eliezer) — Fri, 31 Oct 2008 01:38:00 +0000

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.

Lecture 8 - Long-term Liabilities

noreply@blogger.com (Eliezer) — Fri, 31 Oct 2008 01:11:00 +0000

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.)

Lecture 8 - Long-Term Assets

noreply@blogger.com (Eliezer) — Thu, 30 Oct 2008 23:21:00 +0000

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

original cost
residual value
useful life

There are a few ways to calculate depreciation

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

noreply@blogger.com (Eliezer) — Thu, 30 Oct 2008 23:15:00 +0000

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.

Lecture 8 - The Time Value of Money (cont.)

noreply@blogger.com (Eliezer) — Thu, 30 Oct 2008 22:56:00 +0000

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

Lecture 7 - The Time Value of Money

noreply@blogger.com (Eliezer) — Fri, 24 Oct 2008 01:05:00 +0000

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??

Lecture 7 - Liabilities Part 2

noreply@blogger.com (Eliezer) — Fri, 24 Oct 2008 00:49:00 +0000

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.

Lecture 7 - Current Liabilities

noreply@blogger.com (Eliezer) — Thu, 23 Oct 2008 22:56:00 +0000

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.

Class Discussion Board

noreply@blogger.com (Eliezer) — Thu, 23 Oct 2008 21:59:00 +0000

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

Lecture 6 - Analyzing Financial Statements

noreply@blogger.com (Eliezer) — Thu, 16 Oct 2008 21:58:00 +0000

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.

Lecture 6 - Accounting Conventions

noreply@blogger.com (Eliezer) — Thu, 16 Oct 2008 21:56:00 +0000

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

The Midterm

noreply@blogger.com (Eliezer) — Thu, 16 Oct 2008 21:40:00 +0000

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.

Lecture 4 - Investments (cont.)

noreply@blogger.com (Eliezer) — Fri, 03 Oct 2008 00:49:00 +0000

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

Lecture 4 - Investments

noreply@blogger.com (Eliezer) — Thu, 02 Oct 2008 23:50:00 +0000

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.

Lecture 4 - Accounting for Inventory (cont.)

noreply@blogger.com (Eliezer) — Thu, 02 Oct 2008 21:30:00 +0000

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:

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

Lecture 3 - Accounting for Inventory

noreply@blogger.com (Eliezer) — Fri, 26 Sep 2008 00:59:00 +0000

Accounting for Inventory

In the same way we created metrics for Accounts Receivable, we create the same measures of inventory.

Inventory Turnover = Cost of Good Sold / Average Inventory

Cost of Goods Sold (COGS) is the price that the goods cost the company, not the price at which they were sold.

Similarly, Number of Days in Inventory = 365 / Inventory Turnover

In general, you want a high Inventory Turnover. However, there's a trade off in that it may result in low levels of inventory and possibly being out of stock, resulting in dissatisfied customers.

Compare these numbers against the company's historical numbers and against comparable companies in the same industry.

Inventory Systems - Perpetual vs. Periodic

A perpetual inventory system keeps track of every sale and every purchase. You are constantly up-to-date with your inventory.

For each sale, debit A/R (or Cash) and credit sales (a revenue account). Also, debit COGS (an expense account) and credit Merchandise Inventory (an asset account).

A periodic inventory system tracks sales and purchases, but doesn't dynamically update inventory. Inventory is surveyed by an actual, physical count on a periodic basis.

Beginning Inventory + Purchases = Goods available for sale

Goods available for sale - Ending Inventory = Cost of Goods Sold

Note: The year-end adjustment for periodic inventory is not being tested. We're not covering Freight and Returns nor Accounting for Discounts.

Inclusion in Inventory

If you pay for shipping, tariffs, insurance, etc then they are all considered the costs of inventory, i.e. COGS.

Goods in transit are included in your inventory if your terms of sale specify that you're responsible for it - called FOB Shipping Point. Similarly if you have the same agreement with your customers (FOB Shipping), you don't count it in inventory once it has left your shipping dock.

Goods on consignment are goods that are in your physical possession, but are not technically yours. You're holding them for sale for someone else. Consignment goods are not included in your inventory.

Cost Flow Assumptions

We don't easily know the exact cost of each item that is sold. How do we compute COGS under different cost flow assumptions - LIFO, FIFO and Weighted Average CGS?

LIFO and FIFO are accounting assumptions about the cost of inventory, but does not mean that the physical inventory moved in the LIFO or FIFO order.

In a period of rising prices, which technique results in lower net income? LIFO. Because it results in higher COGS.

Changing techniques requires disclosure as well as permission from IRS for tax purposes. You must use the same technique for both tax accounting and financial accounting. Most companies use the FIFO method.

If sales take place after all the purchases (first example), perpetual and periodic techniques are the same.

Weighted average technique is computationally complex when there are sales in between purchases.

FIFO works out the same whether you use the perpetual or periodic technique.

Lecture 3 - Accounting for Accounts Receivable

noreply@blogger.com (Eliezer) — Thu, 25 Sep 2008 23:43:00 +0000

Accounting for Accounts Receivable

When the sale is made…
Debit A/R
Credit Sales

Then, when the payment comes in…
Debit Cash
Credit A/R

Managerial issues
Accounts Receivable Turnover
Ex: 12,000,000 in sales
Balance in A/R: 1,000,000
Turnover = sales/balance in AR

In our textbook, it says A/R Turnover = Sales/Avg AR balance, where avg AR balance is (starting A/R balance + ending A/R balance)/2

High A/R turnover generally means you’re collecting quickly and is generally good. Looking at turnover trends is also valuable. A problem with high turnover is that sometimes it indicates that the company is requiring customers to pay more quickly, which may make the customers less satisfied and lead to lost sales. Comparison to industry standards is also important.

Another measure of the efficiency of accounts receivable is the Days' Receivables = 365 / A/R Turnover. It indicates how many days it typically takes to collect the receivables.

Getting Cash from Receivables

There are a few ways to get cash from the receivables as quickly as possible.
1. Just wait until the person/firm pays.
2. Take a loan from a bank and use the receivables as collateral
3. Sell the receivables to a third party, called a factor.

The factored receivable may be sold either with or without recourse. Recourse means that if the factor can't collect the receivable, the seller is responsible for the debt. Selling receivables with recourse sells for more than without recourse, because the factor doesn't bear all the risk.

Another way to get cash is by securitizing the receivables in which they are packaged and then sold on the general market, not to a particular factor.

Accounts Receivable Entries

Direct write-off of uncollectible accounts is not allowed, due to the matching rule. You must use the allowance method which creates adjusting entries to estimate how many accounts will be uncollectible, even though you don't know which (or if) accounts will not be paid.

This is done by crediting the "Allowance for Uncollectible Accounts" account (a contra asset account, like accumulated depreciation) and debiting the uncollectible acounts expense account.

The amount that is creditted is done by estimating, usually based on industry standard or company history.

When, subsequently, an account does go bad, the write-off entry is done by crediting Accounts Receivable and debiting the Allowance for Uncollectible Accounts account.

If you eventually do collect the account, there are two steps:
First debit A/R and credit Allowance for Uncollectible Accounts.
Then, record the cash receipt by debiting Cash and crediting A/R.

Estimating Accounts Receivable Collectibility

First method is based on a percentage of all sales. This estimates the amount to debit to Uncollectible Accounts Expense.

The second method is to prepare an aged receivables schedule of each account and the amount that the account is 1-30 days, 31-60 days, 61-90 days and 90+ days overdue. For each category, assign a percentage that will be considered uncollectible. This estimates the amount to credit to the Allowance for Uncollectible Accounts account.

Lecture 3 - Accounting for Cash

noreply@blogger.com (Eliezer) — Thu, 25 Sep 2008 22:50:00 +0000

Accounting for Cash

Management issues related to cash management: Management needs to keep track of cash balances for each period, possibly daily or weekly. For each period, plan and track the beginning balance, inflow, outflow and the ending balance. Every firm of any size has this in some form.

A firm may have several cash accounts. For instance, each store may have a separate account. Payroll may be a separate account. All accounts are rolled up together for the Balance Sheet.

Compensating Balance is the minimum balance that a bank requires the company to maintain on deposit. Compensating balances must be disclosed on the balance sheet - in a footnote.

Cash balances may be significantly positive during some times of the year. Companies invest in short-term commercial paper with their excess cash. Commercial paper are notes from other firms. This bypasses the banks and is called disintermediation. Notes with maturing periods of less than 270 days do not need to be registered with the SEC. Commercial paper is unsecured debt, but is preferred over common stock. Get rates for commercial paper here. Commercial paper rarely defaults and is considered very liquid.

How is commercial paper classified on the balance sheet? Since it's so liquid, it's lumped in with cash if it has a maturity of less than 90 days. If it's more than 90 days, it's an investment. Frequently, the balance sheet says "cash or cash equivalents". The equivalents may include commercial paper.

The real market for commercial paper is short-term money market mutual funds. Recently, many money market funds faltered and the government had to step in to rescue them. The problem with money market funds faltering is that they supply funds to the borrowing companies. If the borrowing companies wouldn't be able to secure funds, it would have a major effect on those companies.