NORTHEASTERN UNIVERSITY

COLLEGE OF BUSINESS ADMINISTRATION

M aster of Science in F inance

Review Module #1

BASIC ACCOUNTING

I. THE ROLE OF ACCOUNTING

 LEARNING OBJECTIVES

 Be Able to Describe the Purpose of Accounting

 List and Define the Three Criteria for Determining Generally Accepted Accounting
Principles (GAAP)

 Know Why Most Companies Conform to GAAP

 Why Does the Finance Professional Need to Understand Accounting?

 WHAT IS ACCOUNTING AND WHY DOES THE FINANCE PROFESSIONAL NEED
IT?

 Definition of Accounting

Accounting is the “ process of identifying, measuring, and communicating economic

information to permit informed judgements and decisions by the
users of the information.”

Source: American Accounting Association, A Statement of Basic Accounting

Theory (Sarasota, FL: 1966) p. 1

 The Finance Professional and Accounting

The finance professional clearly needs to make informed decisions and judgements
based on relevant economic information

 investment analysis

 corporate decision-making

 fund management

 mergers and acquisitions

etc.

Accounting supplies the F INANCE PROF ESSIONAL with the information she
or he need to make economically relevant and informed decisions.
 WHAT IS THE PURPOSE OF ACCOUNTING?

The purpose of accounting is to provide the information that is necessary to make

economically relevant and informed judgments about an organization

 The Organization

Organizations (groups of people) form to provide an efficient means of

accomplishing one or more objectives. For instance, a firm might be organized to
(i) create value for shareholders, (ii) provide high quality software products to
business users, and (iii) offer rewarding and challenging opportunities to
employees.

 Resources

Organizations use resources in order to accomplish their objectives. Some

examples of commonly required resources are:

 labor (human capital)

 buildings and fixtures (e.g., a desk)
 equipment (e.g., manufacturing equipment, delivery trucks)
 services (e.g., janitorial, legal)

 Financing

Organizations must finance (pay for) their resources. Money used to finance the
resources of an organization is often called capital. The two basic sources of
capital are:

 equity: money supplied by the owners of the firm

 debt: money that is borrowed and must be repaid

Comment: In finance, capital is wealth used to create more wealth!

 What Information does Accounting Provide?

Accounting provides information about the resources of an organization, how they

are financed, and the results achieved through using them

 TYPES OF ACCOUNTING INFORMATION

  Operating Information

Accounting provides information for the day-to-day operations of the organization.

For example, someone must keep records of wages that are due employees, the
amount of product that is available for sale, expenses that are owed to suppliers, etc.
Such information is essential to the efficient day-to-day operations of an
organization. Suppose that you called a mail order catalogue to purchase and item,
say a pepper grinder for your kitchen. You would reasonably expect the
salesperson to be able to inform you (i) if the item were in stock or(ii) when you
could expect the item to be available. Accounting systems allow the salesperson
to provide you with this type of information.

 Financial Accounting

Financial accounting provides information that is available to managers as well as

parties external to the organization (regulators, shareholders, banks and other
creditors, investment advisers, fund managers, the general public, etc.). Most of
us would like to have information that is tailored to our specific needs. Such an
information system is, at least for the present time, impractical if not impossible.
Thus, we have to rely on financial accounting reports that are prepared according to
some generally accepted accounting principles (GAAP). We will discuss these
principles a little later.

 our discussion of accounting centers primarily around financial

accounting and how it is used by the finance professional

 Managerial Accounting

Managers cannot examine every detail of the operating information of the firm, so
they rely on internal summaries known as management accounting information.
Managers use this information for (i) planning (including budgeting), (ii)
implementation, and (iii) control (communication, motivation, feedback, and
appraisal)

 A FRAMEWORK FOR FINANCIAL ACCOUNTING

 Accounting as a Language
 Accounting is the language of finance. In many languages, the exact meaning of
words can change by geographic area.

 fried potatoes purchased from McDonalds in Boston are known as fries and
a package of fried potatoes purchased from a vending machine at
Northeastern University are known as chips
 fried potatoes purchased at McDonalds in Great Britain are called chips
and the fried potatoes purchased in a package from a vending machine are
known as crisps

The languages of accounting and English have similar differences.

 net worth commonly refers to the monetary value of something

 in accounting, the term net worth has a specific definition that may often
have little relation to an organization’s true value
 the term asset denotes something that is favorable and the term liability
denotes something that is unfavorable in daily usage
 in accounting, the terms asset and liability are neither favorable or
unfavorable

The meaning of terms in accounting is determined by rules known as a generally

accepted accounting principles (GAAP). The finance professional needs a basic
understanding of GAAP

 Criteria for Determining Accounting Principles

General accounting principles are usually adopted according to how well they meet
three criteria: relevance, objectivity, and feasibility.

 relevance is the extent that information is meaningful and useful to those

who need to know about an organization
 objectivity is the extent that information is not influenced by the personal
bias or judgement of those who produce it
 feasibility is the extent that it can be implemented without undue cost or
complexity

 Generally Accepted Accounting Principles (GAAP)

The rules of accounting are known as generally accepted accounting principles

(GAAP) and are established by the Financial Accounting Standards Board (FASB)

 FASB was created in 1973 and consists of seven leading accountants who
 work full time on developing new principles and modifying existing
principles. A professional staff provides research support to the board.
The FASB is supported by private businesses and the accounting profession
with an annual budget of over $10 million. The FASB is not affiliated with
the federal government.

 Why do Firms Use GAAP?

Businesses are not legally required to adhere to GAAP, but there are several good
reasons for them to do so.

 The reports of most companies are prepared and certified by a certified

public accountant (CPA). A CPA is licensed by the state and has
demonstrated a level of professional competence established by the
professional organization of CPA’s, the American Institute of Certified
Public Accountants (AICPA). The AICPA requires that its members call
to public attention any company that fails to adhere to GAAP. Hence,
questions are raised about companies that fail to use GAAP -- What are they
trying to hide? Most companies want to avoid this distinction.
 The Securities and Exchange Commission (SEC)requires that publicly held
corporations (specifically, those with 500 or more shareholders and at least
$5 million in assets) conform to GAAP
 REVIEW QUESTIONS

 What is the purpose of accounting?

 List and Define the Three Criteria for Determining Generally Accepted Accounting
Principles (GAAP).

 Why do most companies conform to GAAP?

 Why does the finance professional need to understand accounting?

 REVIEW QUESTIONS -- SOLUTIONS

 What is the purpose of accounting?

The purpose of accounting is to provide the information that is necessary to make

economically relevant and informed judgements about an organization

 List and Define the Three Criteria for Determining Generally Accepted Accounting
Principles (GAAP).

relevance is the extent that information is meaningful and useful to those who need
to know about an organization
objectivity is the extent that information is not influenced by the personal bias or
judgement of those who produce it
feasibility is the extent that it can be implemented without undue cost or complexity

 Why do most companies conform to GAAP?

The reports of most companies are prepared and certified by a CPA. The AICPA
requires that its members call to public attention any company that fails to adhere
to GAAP. Most companies doe not wish to appear as if they are trying to hide
something, hence they conform to GAAP.
The Securities and Exchange Commission (SEC)requires that publicly held
corporations (specifically, those with 500 or more shareholders and at least $5
million in assets) conform to GAAP

 Why does the finance professional need to understand accounting?

The finance professional needs to make informed decisions and judgements based
on relevant economic information.
II. FINANCIAL STATEMENTS

 LEARNING OBJECTIVES

 Be able to describe an income statement, a balance sheet, and a statement of cash

flows in very general and basic terms

 Understand the concept of accrual accounting and how it creates differences

between accounting concepts such as net income and cash flow

 Know the difference between the current market value and how an asset is recorded
on the balance sheet at cost

 Be able to compare and contrast a “stock” financial statement and a “flow”

financial statement
 TYPES OF FINANCIAL STATEMENTS

Accounting information is disseminated through financial reports. There are three basic
financial reports under GAAP: (i) the balance sheet, (ii) the income statement, and (iii) the
statement of cash flows. These statements are prepared using the principles of accrual
accounting and historical cost.

 The Balance Sheet

 Gives a summary of the accumulated resources of the firm (assets) and

how these resources are financed (liabilities and equity). The liabilities
and equity represent“ claims” on the assets.

 Note that the assets of a firm are primarily Real Assets (a real or tangible
item) and the Liabilities and Equity are Financial Assets (a claim on a real
asset -- e.g., common stock is one type of claim on the assets of a firm)

 When balance sheets are presented side by side, the assets are presented on
the left and the liabilities and equity on the right. Sometimes people refer
to the “left side” (assets) of the balance sheet or the “right side” (liabilities
and equity) of the balance sheet.

 The Income Statement

 The income statement provides a description of the firm’s operations over a

period of time.

 Effectively, the income statement is a summary of the revenues (the

creation of an asset from selling product or services; also known as sales)
that a firm has produced and the expenses (the reduction in an asset incurred
as a result of providing a product or service) the firm incurred in producing
the revenues.

 Revenues less expenses is income. The term income is usually modified to

indicate at what stage of the operations it is being measured. Total
revenues less total expenses is net income.
 Accrual Accounting

 Revenues and expenses are charged to the period in which they are
generated. Actual cash flows (inflow or outflows) may be in a different
period.

example: a firm sells a product in December, 2006 but does not

receive the cash payment until February, 2007 -- the revenue
is recognized in 2006 even though the cash is not receive
until 2007

 Certain expenses, such as depreciation or amortization, represent

accounting conventions and not real cash expenditures.

 Cash flow is the essential element in creating the real economic value of an
organization. Net Income is not cash!

 Assets and Historical Cost

 Economic resources of a firm as called assets

 Assets are generally recorded on the balance sheet at the price paid for the
asset -- this price is the asset’s cost

 The amount recorded on the balance sheet for an asset may have little
relation to its current economic or market value

example: some land was purchased in 1999 and put on the balance
sheet at cost -- this cost is not likely to be an accurate
reflection of the value of the land today

 The Statement of Cash Flows

 The statement of cash flow (cash flow statement)explains the change in a

firm’s cash position over a particular period

 The cash flow statement is derived from the income statement and the
balance sheet and must “adjust” for non-cash entries that arise from accrual
accounting, non-cash expenses such as deprecation, and additions to assets
at cost

 We will discuss the cash flow statement in the next learning module,
“Analyzing Financial Statements”
 Stock Reports Versus Flow Reports

 A stock report is a financial statement that reports information as of a

specific point in time. On the other hand, a flow report is a financial
statement that reports information covering a specified period of time.

 The balance sheet is a stock report and the income statement and the
statement of cash flows are flow reports.

 People refer to the balance sheet as a as a stock report since it describes the
stock of assets available as of a given date. Others describe the balance
sheet as a “snapshot” of the firm’s financial position because it provides a
picture of the firm’s assets at a point in time. A third analogy likens the
balance sheet to a reservoir or pool since it represents the available supply
of assets.

 In contrast, the income statement and the cash flow statement describe
changes in financial position. These flow reports are like “moving
pictures” or a “stream” that increases or decreases the level of the “pool”.
 REVIEW QUESTIONS

 List the three basic financial statements under GAAP. Describe each of these
statements in very basic and general terms.

 What is accrual accounting?

 What is the difference between a stock statement and a flow statement?

 Classify the income statement, the balance sheet, and the statement of cash flows as
a stock report or a flow report.

 Land purchased 20 years ago is on the balance sheet at $15,000,000. What does
this tell you about the value of the land today? Twenty years ago?
 REVIEW QUESTIONS -- SOLUTIONS

 List the three basic financial statements under GAAP. Describe each of these
statements in very basic and general terms.

Income statement: A statement that provides a description of the firm’s

operations over a period of time.
Balance Sheet: A statement that gives a summary of the accumulated resources of
the firm (assets) and how these resources are financed (liabilities and equity).
Statement of Cash F lows: A statement that explains the change in a firm’s cash
position over a particular period

 What is accrual accounting?

Accrual accounting is an accounting principle in which revenues and expenses are

charged to the period in which they are generated.

 What is the difference between a stock statement and a flow statement?

A stock report is a financial statement that reports information as of a specific point

in time. On the other hand, a flow report is a financial statement that reports
information covering a specified period of time.

 Classify the income statement, the balance sheet, and the statement of cash flows as
a stock report or a flow report.

Balance Sheet: Stock Report

Income Statement: Flow Report
Statement of Cash F lows: Flow Report

 Land purchased 20 years ago is on the balance sheet at $15,000,000. What does
this tell you about the value of the land today? Twenty years ago?

The amount tells us little about the value of the land today. It is feasible that the
land could be worth more or less than $15,000,000, but likely more given the
general appreciation of land values. We know, however, that the land was worth
$15,000,000 twenty years ago since assets are recorded at cost.
III. THE BALANCE SHEET

 LEARNING OBJECTIVES

 Be Familiar with the Balance Sheet and Balance Sheet Categories

 Understand the Principle of Double-entry Accounting

 Know the Fundamental Accounting Equation

 Be Able to Classify Any Balance Sheet Category as a Current Asset, a Long-term

Asset, a Current Liability, a Long-term Liability, or Equity

 Know How to Account for the Sell of Common Stock

 Understand the Relationship Between Accumulated Depreciation, Depreciation

Expense, and Fixed Assets
 The Fundamental Accounting Equation

A fundamental principle underlying the balance sheet is that the assets of the firm
must all be financed by liabilities and owners’ equity

ASSETS = LIABILITIES + OWNERS’ EQUITY

 Assets ≡ the economic resources of the firm

cash, inventories, land, buildings, etc.

 Liabilities ≡ the claims of creditors; a financial obligation to an outside

party arising from an event that has already occurred
debt, money owed to vendors, taxes owed the government, etc.

 Equity ≡ the claims of the owners of the firm

common stock, capital in excess of par, retained earnings

 When balance sheets are presented side by side (account form), the assets
are presented on the left and the liabilities and equity on the right.
Sometimes people refer to the “left side” of the balance sheet or the “right
side” of the balance sheet. Alternatively, the balance sheet may be
presented with assets on the top and liabilities and owners’ equity below
(report form).

 Double Entry Accounting

Any event (transaction) that impacts one side of the balance sheet must have an
equivalent impact on the other side of the balance sheet: the fundamental
equation of accounting must always hold.

 Example #1: A company borrows $50,000 from a bank and owners

contribute and additional $50,000 of their own money in equity

Assets Liab. & Owners’ Equity

Cash $100,000 Bank Loan $50,000

Owners’ Equity $50,000

Total Assets $100,000 Total Liab. & Equity $100,000

 A transaction can impact two accounts on one side of the balance sheet
(e.g., assets) without impacting the other side of the balance sheet (e.g.,
liabilities and owners’ equity) as long as the total amounts still balance.
  Example #2: The company in the previous example spends $60,000 on
goods (inventory) to be sold to customers.

Assets Liab. & Owners’ Equity

Cash $40,000 Bank Loan $50,000

Inventories $60,000 Owners’ Equity $50,000

Total Assets $100,000 Total Liab. & Equity $100,000

In this case, cash declines by $60,000 and inventories increase by $60,000

so total assets remain constant.

 Account Categories and Subheadings

Individual assets are typically grouped into classifications of related group items
known as account classifications

 Account Classification: A group of related accounting items

cash in lieu of cash in checking and cash in savings

inventory in lieu of each item in stock
accounts receivable in lieu of each bill owed the company

 Individual items in one category should be (i) similar to the other items in
the category in significant ways and (ii) essentially different from items in
other categories

 Categories with certain similarities are typically listed together under

subheadings on the balance sheet

e.g., current liabilities, plant and equipment, etc.

 Example -- Murcheson Carpet Company

An example of a balance sheet for a subchapter S corporation, Murcheson Carpet

Company, appears on the next page. A subchapter S corporation is a corporation
designed for small business people that allows the owner to report the income of the
firm on his or her personal 1040 tax filing. Murcheson carpet is a small retailer of
carpet and other floor coverings. We will use this example to discuss the various
account categories and subheadings on the page following the balance sheet.
 EXAMPLE -- Murcheson Carpet Co.

Murcheson Carpet Company, Inc.

Balance Sheet
October 31, 2005, 2004, and 2003
ASSETS 2005 2004 2003
CURRENT ASSETS:
Cash $ 41,582 43,429 16,811
Accounts Receivable 51,034 30,926 32,914
Inventory 43,244 40,018 65,443
Prepaid Expenses 3,061 2,202 1,275
TOTAL CURRENT ASSETS 138,921 116,575 116,443
EQUIPMENT
Leasehold improvements 780 780 780
Fixtures and equipment 10,332 10,332 10,332
Service vehicles 39,666 39,666 40,073
50,778 50,778 51,075
Less: Accumulated Depreciation (38,338) (33,453) (27,589)
NET EQUIPMENT 12,440 17,325 23,486
TOTAL ASSETS $151,361 $133,900 $139,929

LIABILITIES & SHAREHOLDERS' EQUITY

CURRENT LIABILITIES
Current Maturities of Long-term Debt $ -0- $ -0- $ 2,225
Accounts Payable 17,021 20,626 14,344
Accrued Liabilities 3,058 4,007 3,734
Loans From Shareholders 35,000 -0- -0-
TOTAL CURRENT LIABILITIES 55,079 24,633 20,303
SHAREHOLDERS' EQUITY:
Common Stock-$10 Par Value 1,000 1,000 1,000
Retained Earnings 95,282 108,267 118,626
TOTAL SHAREHOLDERS' EQUITY 96,282 109,267 119,626
TOTAL LIAB. & SHAREHOLDER'S EQUITY $151,361 $133,900 $139,929
COMMENTS ON THE BALANCE SHEET FOR MURCHESON CARPET COMPANY

1. The name of the company (Murcheson Carpet Company, Inc.), the name of the financial
report (Balance Sheet), and the moment(s) in time (October 31, 2005, 2004, and 2003) are
presented at the top of the statement. There are “snapshots” presented for three
consecutive years. It is not uncommon to present several years on the same balance sheet.
Cur rent Assets
2. The first subheading under Assets is Cur rent Assets. Current assets are assets that are
expected to be realized in cash, sold, or consumed within one year’s time or the current
operating cycle, whichever is longer (e.g., inventory, accounts receivable, marketable
securities, etc.). Note: Most firms have an accounting cycle of one year. Certain entities
(e.g., some mining concerns) have accounting cycles longer than a year. The current assets
of Murcheson Carpet are cash, accounts receivable, inventory, and prepaid expenses.
3. Cash is money that is readily available for disbursement. Most cash is in checking
accounts in banks, with the remaining cash in cash registers, safes, petty cash boxes, or
otherwise stored at the firm.
4. Accounts r eceivable is money owed to the firm by its customers. Accounts receivables
are listed net of any amounts that are not expected to be repaid. The amount not expected
to be repaid is known as an allowance for doubtful accounts. Note: If money were owed
the company by entities other than customers, it would appear under the categories notes
receivable or other receivables. Murcheson does not have these categories.
5. Inventory is aggregate of items (i)held for sale in the ordinary course of business, (ii)
currently in the process of production, and (iii) materials soon to be used in the process of
production. In Murcheson Carpet’s case, the inventory is carpet and floor covering and is
in class (i). A manufacturing firm would also have class (ii) and class(iii) inventory.
Class (ii) inventory is known as work in process and class (iii) inventory is known as raw
materials. Class (i) inventory for a manufacturer is known as finished goods.
6. Pr epaid expenses represent assets that have been paid for in advance (usually of an
intangible nature such as a service) and that will expire in the near future. The most
common prepaid expense is insurance coverage. Other prepaid expenses include legal
retainers, consulting or accounting services paid for in advance, or prepaid maintenance
contracts.
7. One fairly common current asset that does not appear on Murcheson Carpet’s balance sheet
is Marketable Securities. Marketable Securities are investments that are very liquid (e.g.,
treasury bills) and that are expected to be turned into cash within one year
Equipment (sometimes known as Plant and Equipment)
8. The (Property, Plant and) Equipment category consists of long-lived (life greater than
one year) assets. This category is often referred to as fixed assets. All assets that are not
current assets (any asset with a “life” longer than one year or the current accounting cycle)
are known as long-term assets.
9. Leasehold impr ovements represent improvements made to a leased facility that must
remain with the facility (e.g., Murcheson installed an automatic door in a warehouse that
they rent)
10. Fixtur es and Equipment describe investment in fixed assets that can be removed from the
premises. In this case, the fixtures are primarily storage rack for carpet and the equipment
is a forklift and tools.
11. Ser vice Vehicles are vans used to transport carpet from the factories to Murcheson
Carpet and from Murcheson Carpet to the customer. Note that these vehicles are
equipment to Murcheson, but would be inventory if they were sitting on a car lot waiting to
be sold.
12. Each of the above equipment categories are listed at cost. Equipment listed at historical
cost is known as gross fixed assets. Gross fixed assets are depreciated (reduced a little
each year) over their useful life to reflect the economic depletion of the asset (e.g.,
eventually a truck becomes useless and most be replaced). The portion of an asset that has
been depreciated is said to be written off. Depreciation will be discussed in more detail a
bit later.
13. Accumulated Depr eciation is the portion of the historical cost of the equipment that has
been written off to date.
14. Net Equipment (also known as Net Fixed Assets) is the historical cost of equipment less
the accumulated depreciation. This is also known as the book value of the equipment.
To the extent that depreciation does not reflect true economic depletion (some assets are
useful long after they are depreciated and others are obsolete well before) book value will
not reflect economic value.
15. Total Assets is the sum of all current assets and net fixed assets.
16. Comments:(i) Murcheson Carpet does not own land. If they did own land, an entry title
Land would appear at the historical cost of the land. Land is never depreciated. (ii)
Sometimes an entry called Other Assets will appear as a long-term asset. Other assets are
tangible long-term assets that are not property, plant, or equipment. Other Assets usually
represent investment in the common stock of another firm for the purposes of controlling
the other company or for long-term gain (e.g., Microsoft invests in a large number of small
high technology software and INTERNET related companies). (iii) Sometime a term
known as Intangible Assets appears in the long-term section. Intangible Assets are
distinguished from prepaid expenses in that their life span is expected to be greater than
one year. Common Intangible Assets include Goodwill, patents, copyright, trademarks,
etc.
17. Additional comments on Intangible Assets.
 Goodwill is generated when one company buys another company for more than the
fair market value of the target company’s assets (e.g., as when IBM purchased
Lotus) in order to obtain the target firm’s reputation, clients, strategic position, etc.
 Patents, trademarks, copyrights, etc. are recorded on their balance sheet at cost.
 All intangible assets are amortized (reduced) over the useful life of the asset.
Amortization is “depreciation” for intangible assets. If the useful life is limited by
law (e.g., patents are limited to 17 years) or agreement (an expiration date on a
franchise) the amortization period cannot be longer. The maximum amortization
period is 40 years.
Cur rent Liabilities
18. Cur rent liabilities are obligations that are expected to be settled within one year or the
current accounting cycle by the use of a current asset (e.g., pay bills with cash) or by
creating another current liability (e.g., using a credit line to pay bills)
19. Cur rent Matur ities of Long-ter m Debt are the payments on long-term debt (debt with an
original maturity or pay-off period of greater than one year) that are due within one year.
Any portion of the debt that is not due within one year is considered long-term and is not a
current liability. Note: Murcheson has an entry for Current Maturities of Long-term Debt
in 2003, but no category for Long-term Debt and no entry for Current Maturities of
Long-term Debt in 2004 or 2005. This indicates that the final payment of a long-term loan
occurred in 2003. Long-term debt can be in the form of a bank loan, a mortgage, publicly
issued bonds, or a private placement of debt.
20. Accounts Payable represents money that is owed to suppliers for goods or services that
they have furnished to Murcheson.
21. Accrued Liabilities (also known as accrued expenses) represent money that has been
earned by outside parties but not yet paid. There is typically not an invoice for these
liabilities. Typical accrued liabilities include interest owed but not yet paid and wages
that have been earned but not paid. Sometimes more descriptive detailed categories are
used such as Interest Payable and Wages Payable.
22. Loans Fr om Shar eholder s represent short-term loans from the owner of Murcheson
Carpet. Other short-term loans include bank loans, lines of credit, and notes payable.
23. Comments: Another fairly common current liability that sometimes appears is Deferred
Revenues (also known as unearned revenues or precollected revenues). These categories
represent payment in advance for services or goods to be rendered at a later date.
Shar eholder s’ Equity
24. The Shar eholder s’ Equity is divided into two sections -- contributed (or paid-in) capital
and retained earnings. Contributed capital is often divided into Common Stock at Par and
Additional Paid-in Capital. Par Value is the stated value (value on the stock certificate)
times the number of shares. If owners have contributed more than par value (as is usually
the case for larger firms) the excess above par will appear as Additional Paid-in Capital.
Murcheson does not have additional paid-in capital, but we will look at an example later.
Note: Par value for most publicly traded firms is $1. Thus, if a firm sells stock for $20, $1
is recorded at par and $19 as additional paid-in capital.
25. Retained Ear nings represents the total earnings of the firm since its inception less the total
dividends that have been paid to shareholders since inception. Note well: RETAINED
EARNINGS ARE NOT CASH.
26. Total Shareholders Equity is the sum of the contributed capital (par and additional
paid-in capital) and retained earnings. Note: Some firms also have preferred stock.
Preferred stock is equity that receives a dividend (before commons stockholders are paid)
but cannot vote for directors. If a firm has preferred stock, the preferred stock is also part
of shareholders’ equity.

 Depreciation

Depreciation accounts for the depletion of fixed assets over time. There are two
types of depreciation techniques -- (i) straight-line depreciation and (ii) accelerated
depreciation.

 Depreciation is an expense on the income statement each year and lowers

the taxable income of the firm. Depreciation is a non-cash expense that
lowers a cash expense (taxes). Thus, most firms want to take as much
depreciation as possible and use an accelerated method for tax purposes.
On the other hand, firms often prefer to take as little depreciation as
possible for reporting purposes in order maximize reported income.

 Str aight-line depr eciation takes the total cost of the asset less an estimated
salvage value and allocates the depreciation over the useful life of the asset

example: Purchase an asset for $1,000,000 with a useful life of 10 years and
an estimated salvage value of $100,000 at the end of the 10 years
Yearly Depreciation = ($1,000,000 - $100,000)/10
Yearly Depreciation = $90,000
  Accelerated depr eciation allows more of the asset to be depreciated in its
early years. There are several methods, but the system that most quickly
depreciates an item and that can be legally used for tax purposes is known
as the Modified Accelerated Cost Recovery System (MACRS) which
consists of a technique known as double-declining balance with a switch to
straight-line where optimal. Most accounting and finance texts contain
charts showing the allowable depreciation under MACRS (see, e.g.,
Brealey and Myers (2006) p. 123). From the firm’s perspective, MACRS
is the economically optimal system for tax purposes and for
decision-making.

 Accumulated depr eciation is the sum of all of the annual depreciation

expenses for assets that are “on the books” (still owned and in use by the
firm). Each year’s depreciation expense is added to last year’s
accumulated depreciation to get the current year’s accumulated
depreciation.

 Accounting for Shareholders’ Equity

 When a firm sells stock, the stock has a stated or par value (usually $1).
Money received for the stock in excess of par (or stated) value is known as
additional paid-in capital. Although some companies list the total paid-in
capital simply as common stock, most list the par value and the additional
paid-in capital under separate categories on a firm’s balance sheet.

example: A firm issues 100,000 shares of common stock at a price of

$10 per share and holds the proceeds in cash. The par value
of the stock is $1.

Δ Par Value = 100,000 X $1 = $100,000

Δ Additional Paid-in Capital = 100,000 X $9 = $900,000
Δ Cash = 100,000 X $10 = $1,000,000

Assets Liabilities & Equity

Cash ↑$1,000,000 Common Stock - $1 par ↑$100,000

Add. Paid-in Capital ↑$900,000
 REVIEW QUESTIONS

 Suppose that a firm has total assets of $1,000,000, Long-term debt of $400,000,
total common equity of $400,000, and preferred equity of $50,000. What are the
firm’s current liabilities?

 Identify the following as a current asset, fixed asset, current liability, long-term
debt, or common equity.

a. Retained Earnings b. Accounts Receivable

c. Cash d. Bank Notes payable, current
e. Inventory f. Plant and Equipment
g. Accounts payable h. Bonds

 In 2005 a firm had net fixed assets of $45,200,000. In 2006, the firm neither
purchased nor sold any fixed assets, but the net fixed assets account declined to
$42,375,000. To what do attribute this decline?

 A firm sells one million shares of new common stock with a par value of $1.00 per
share and a market price of $20.00 per share net to the firm. Management uses the
proceeds of the stock offering to buy a new automated manufacturing system.
What balance sheet accounts will be affected by these transactions and what will
the changes be?
 REVIEW QUESTIONS -- SOLUTIONS

 Suppose that a firm has total assets of $1,000,000, Long-term debt of $400,000,
total common equity of $400,000, and preferred equity of $50,000. What are the
firm’s current liabilities?

$150,000; Current Liabilities = Total Assets - (LTD + EQUITY)

$150,00 = $1,000,000 - ($400,000 +
$450,000)

 Identify the following as a current asset, fixed asset, current liability, long-term
debt, or common equity.

a. Retained Earnings Common Equity

b. Accounts Receivable Current Asset
c. Cash Current Asset
d. Bank Notes payable, current Current Liability
e. Inventory Current Asset
f. Plant and Equipment Fixed Asset
g. Accounts payable Current Liability
h. Bonds Long-term Debt

 In 2005 a firm had net fixed assets of $45,200,000. In 2006, the firm neither
purchased nor sold any fixed assets, but the net fixed assets account declined to
$42,375,000. To what do attribute this decline?

The firm had depreciation expense in 2006 of $2,825,000.

 A firm sells one million shares of new common stock with a par value of $1.00 per
share and a market price of $20.00 per share net to the firm. Management uses the
proceeds of the stock offering to buy a new automated manufacturing system.
What balance sheet accounts will be affected by these transactions and what will
the changes be?

Assets
Gross Fixed Assets (or equipment) increases by $20,000,000
Liabilities and Equity
Common Stock at par increases by $1,000,000.
Paid-in Capital in excess of par increases by $19,000,000.
IV. THE INCOME STATEMENT

 LEARNING OBJECTIVES

 Understand the Fundamental Income Statement

 Be Able to Identify Each of the Categories on a Basic Income Statement

 Given Net Income and Dividends Paid, Be Able to Calculate the Change in
Retained Earnings
 The Basic Idea

An income statement is merely an accounting of the revenues generated by a firm

over the accounting period (e.g., one year)less the expenses incurred while
generating these revenues

 The fundamental income statement equation

REVENUES - EXPENSES = NET INCOME

 net income may be positive or negative

 income is sometimes called the “residual” revenue and “belongs” to the

common shareholders who are known as the “residual claimants”

 The Relation Between Net Income, Dividends and Shareholders’ Equity

Each period a firm’s retained earnings (i) increase or decrease by the amount of net
income and (ii) decrease by the amount of dividends paid

 The fundamental relationship between net income, retained earnings, and

dividends

Δ Retained Ear nings = Net income - Dividends

⇒ Retained Ear ningst = Retained Ear nings t-1 + Δ Retained Ear nings

 example #1: The Husky Dog Food Company generated a

net income of $300,000 in 2006 and decided to pay
$120,000 in dividends to shareholders. The net effect was
that retained earnings increased by $180,000.
Δ Retained Ear nings = $300,000 - $120,000 = $180,000

 example #2: The Terrier Dog leash company had a net

income of -$500,000 in 2006. Despite the loss,
management chose to pay $100,000 in dividends. The net
effect was that retained earnings declined by $600,000.
Δ Retained Ear nings =-$500,000 - $100,000 = -$600,000
 Income Statement Format

The income statement is also known as the profit and loss statement, the statement
of earnings, or the statement of operations. A minimal basic format is given
below.

Net Sales (net sales revenue)

less Cost of Goods Sold (cost of sales)
Gross Profit
less Operating Expenses (may be listed in more detail)
Depreciation Expense
Earning Before Interest and Taxes (EBIT, Operating Profit)
less Interest
Earnings Before Taxes (EBT)
less Taxes
Net Income

 The term net sales indicates that the revenue figure is net of anticipated
returns, allowances for bad debt, and of trade discounts (e.g, discounts
offered to customers who pay early)

 The term cost of sales represents costs directly associated with the reduction in
an asset (usually inventory) as a result of the sale. For instance, suppose that a
consumer purchases a “surround sound” stereo system. The cost of sales
represents the material and labor costs directly associated withe manufacturing the
stereo system. It does not include overhead, miscellaneous salaries,
commissions, etc.

 Operating expenses is a category that represents expenses of the firm that occur
during normal operations (rent, utilities, insurance, etc.) but that are not direct
product costs.

 Depreciation expense is the depreciation of fixed assets for the current accounting
period.

 Earnings before interest and taxes (EBIT) is an intermediate profit measure that
excludes the influence of debt (interest) and taxes. EBIT is often called operating
profit.

 Interest expense is the interest paid on debt for the accounting period. Some
firms also show interest income from investments.

 Taxes (provision for income taxes)represents all federal, state, and local taxes
resulting from the current year’s operations.

 Net Income is revenues less all expenses

 Example -- Mur cheson Car pet Company

The Income Statement for Murcheson Carpet Company is shown below. Explanatory comments
follow

Murcheson Carpet Company, Inc.

Statement of Income and Retained Earnings
F or the Years Ended October 31, 2005, 2004, and 2003

2005 2004 2003

Net Sales $591,351 $660,532 $650,026
Cost of Sales 454,661 515,289 511,798
GROSS PROFIT 136,690 145,243 138,228
OPERATING EXPENSES:
Officers' salaries 64,200 50,100 50,100
Depreciation expense 4,885 7,858 6,407
Vehicle expense 6,696 7,638 12,647
Other expenses 34,825 39,410 38,308
110,606 105,006 107,462
PROFIT FROM OPERATIONS 26,084 40,237 30,766
OTHER INCOME (EXPENSE):
Discounts earned 13,707 18,657 20,781
Gain (loss) on disposal of assets -0- (463) 2,400
Interest Income 1,376 1,217 1,283
Interest expense -0- (53) (370)
15,083 19,358 24,094
INCOME BEFORE TAXES 41,167 59,595 54,860
Provision for Income Taxes -0- -0- -0-
NET INCOME 41,167 59,595 54,860
Retained Earnings, Beginning of year 108,267 118,626 92,156
Less Dividend Paid (54,152) (69,954) (28,390)
RETAINED EARNINGS, END OF YEAR $ 95,282 $108,267 $118,626
COMMENTS ON THE BALANCE SHEET FOR MURCHESON CARPET COMPANY

1. The name of the company (Murcheson Carpet Company, Inc.), the name of the financial
report (Statement of Income and Retained Earnings), and the operating periods (Years
ending October 31, 2005, 2004, and 2003) are presented at the top of the statement. There
are income statements presented for three consecutive years. It is not uncommon to
present several years on the same balance sheet.
2. Net Sales are revenues net of anticipated returns, allowances for bad debt, and trade
discounts. The term gross sales is used to indicate if revenues are before deductions for
allowances.
3. Cost of Sales is the direct cost of goods sole which is, in this case, carpet.
4. Gr oss Pr ofit is Net Sales less Cost of Sales.
5. Oper ating Expenses (also sometimes call Selling, General, and Administrative Expenses)
represent expenses associated with the operations of the firms that are not directly related
to the goods that are sold. Operating expenses are broken down into more detailed
categories -- Officer s’ Salaries, Depreciation Expense, Vehicle Expense (maintenance
and fuel) and Other Expenses (rent, utilities, etc.).
6. Pr ofit From Oper ations (also called Operating Profit or sometimes Earnings Before
Interest and Taxes) is Gross Profit less Operating Expenses.
7. Other Income (Expense) represents revenues and expenses that are not of an operating
nature. Discounts Ear ned are trade discounts from suppliers as a result of paying
invoices early. Gain (loss) on disposal of assets arises from selling fixed assets at a price
that is different from the book value (e.g., if the firm sells a truck for more than its book
value (gross value less accumulated depreciation) a gain results). Inter est Income is
interest earned on deposit accounts and Inter est Expense is interest paid on loans.
8. Income Befor e Taxes is Profit From Operations less Other Income (Expense).
9. Pr ovision for Income Taxes represents the taxes arising from this year’s operations. In
this case, taxes are zero since the owners report all of the firm’s profits on their personal
1040 tax filings. Larger firms are typically ‘C’ corporations and pay taxes at the firm
level.
10. Dividends Paid are the dividends paid to the owners. Note that for 2004 and 2005
dividends exceeded net income and retained earnings declined, but that for 2003 net
income exceeded dividends and retained earnings increased. Owners of subchapter S
corporations often pay themselves adequate dividends to cover the firm’s taxes which they
must personally pay.
 REVIEW QUESTIONS

 A firm has total revenues of $2,000,000, Cost of Sales of $1,200,000, and Earnings
before taxes of $400,000. If the firm’ combined average federal and state tax rate
is 40%, what is the firm’s net income?

 Arrange the following terms to form an income statement.

Earnings Before Taxes Cost of Goods Sold Sales

Earnings Before Interest and Taxes Gross Profit
Depreciation Taxes Interest Expense
Sales and Administrative Expense Net Income

 Suppose that a firm earns net income of $2,000,000 and pays dividends of
$750,000. What is the combined impact of these two actions on the retained
earnings account?
 REVIEW QUESTIONS -- SOLUTIONS

 A firm has total revenues of $2,000,000, Cost of Sales of $1,200,000, and

Earnings before taxes of $400,000. If the firm’ combined average federal and
state tax rate is 40%, what is the firm’s net income?

Net Income = Earnings Before Taxes * (1-Tax Rate)

$240,000 = $400,000 * (1-.4)

 Arrange the following terms to form an income statement.

Earnings Before Taxes Cost of Goods Sold Sales

Earnings Before Interest and Taxes Gross Profit
Depreciation Expense Taxes Interest Expense
Sales and Administrative Expense Net Income

Sales
less Cost of Goods Sold
Gross Profit
less Depreciation Expense
less Sales and Administrative Expense
Earnings Before Interest and Taxes
less Interest Expense
Earnings Before Taxes
less Taxes
Net Income

 Suppose that a firm earns net income of $2,000,000 and pays dividends of
$750,000. What is the combined impact of these two actions on the retained
earnings account?

Δ Retained Earnings = Net income - Dividends

$1,250,000 = $2,000,000 - $750,000

Retained Earnings increase by $1,250,000.