FIN 480E Accounting Clinic 1

Gross Margin

Operating Income before Tax (EBIT)

Operating Income before Tax – Interest Expense

Net Income

Net income available to Common

Cash from Operations + Cash from Investing + Cash from Financing

To provide relevant information about the cash inflows and outflows of an enterprise during a period.

Cash Flows from Investing Activities - Investing activities involve acquiring and disposing of debt or equity investments, property, plant and equipment and other productive assets used in the production of goods or services by the enterprise (other than materials that are part of the enterprise's inventory).

Investing activities involve acquiring and disposing of debt or equity investments, property, plant and equipment and other productive assets used in the production of goods or services by the enterprise (other than materials that are part of the enterprise's inventory).

Financing activities involve obtaining resources from owners and providing them with a return on their investment; borrowing money and repaying amounts borrowed, and obtaining and paying for other resources obtained from creditors on long-term credit.

Contributed capital which represents stockholders’ investment – common stock (par value) and additional paid in capital, and retained earnings which equals cumulative net income minus cumulative dividends since the formation of the company. (Dividends are distributions of assets to stockholders.)

To avoid earnings fluctuations some of the unrealized gains/losses are reported in “other comprehensive income” and not included in net income.

Ending equity = Beginning equity + Total (comprehensive) income – Net payout to shareholders

Comprehensive income = Net income + Other comprehensive income

Net payout to shareholders = Dividends + Share repurchases -Share issues

Fair value accounting
Assets and liabilities are reported at their “fair value” and gains and losses from revaluing them are reported in the income statement or as part of other comprehensive income in the equity statement. Fair value is either market value or an estimate of value.

Historical cost accounting
Assets and liabilities are reported at their historical cost (the dollar amount paid when they were acquired or incurred). In subsequent periods, those costs are amortized to the income statement as the assets are deemed to have been used up in operations or as liabilities accrue costs.
GAAP accounting uses both types of measurement.

Under U.S. GAAP, the following assets and liabilities are approximately at market value:
Cash and Cash Equivalents, Short-term investments, Accounts payable, Equity Investments considered trading securities or “available for sale.” See Accounting Clinic III.

1. Net Accounts Receivables (net of estimate of likely bad debt.) 2. Accrued and Estimated Liabilities. Note that debt (short-term and long-term) is at historical cost but that is typically close to fair value)

1. Long-term Tangible Assets (depreciated) 2. Recorded Intangible Assets (amortized) 3. Goodwill (not amortized). These assets can be written down if their value is deemed to have been impaired, but are never written up (in the U.S.).

1. Inventories: Lower of cost or market rule applies
2. Debt investments
-Trading
-Available-for-sale
-Held to maturity
3. Equity investments
-Trading
-Available-for-sale
See Accounting Clinic III

1. The earnings process is substantially accomplished
2. Receipt of cash is reasonably certain

Expenses are recognized in the income statement by their association with revenues for which they are incurred. The earnings number reflects net value added from revenues, that is, net of matched expenses. Go to Accounting Clinic II for more on matching

Inventory, beginning XXX
+ Purchases XXX
Goods available for sale XXX
- Inventory, ending (XXX)
Cost of Goods Sold XXX
The beginning balance of inventory and purchases of goods during the year sum up to the total goods that the firm could have sold during the year.
The ending balance of inventory (usually available from physical count) is subtracted to get the cost of the goods actually sold.

Therefore total cost of goods sold was:409,000+2,598,000-547,000=2,460,000

payment to suppliers.

1. Accounts Payable adjustment – payment might not reflect the entire expenditure on inventories. Some inventories were purchased on account. 2. Inventory adjustment – inventory is a pure accrual concept and is recognized in order to match the expense (COGS) with revenue (the amount we received for the goods sold). More about the matching concept in Accounting Clinic II.

Examples:
1. Assets omitted from the balance sheet: R&D and brand assets 2. Off-balance-sheet obligations not recognized (FIN 46 helps to rectify) 3. Losses on conversions into common stock and options settled with common stock are not recognized (SFAS 150 attempts to rectify)

Examples:
Excessive restructuring charges (SFAS 146 helps here)
Biased estimates of bad debts, sales returns, warranties
Aggressive revenue recognition
Conservative revenue recognition: Creation of a “cookie jar” with unearned revenue
“Creative accounting” that yields form over substance: using “bright lines” in GAAP to obscure; structural engineering

1. Understand GAAP and its limitations 2. Appreciate the relevance-reliability tradeoff 3. Recognize unresolved issues in GAAP 4. Recognize where choices can be made

1. How sensitive are earnings to estimates?
2. How would you characterize the revenue recognition – aggressive or conservative?
3. Does the application of GAAP “faithfully represent” the business? These issues will come to the fore as we proceed through the book