Accounting For Fun and Profit. A Guide To Understanding Financial Statements - Lawrence A. Weiss

Accounting for Fun and Profit Financial Accounting
WEISS
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students expecting to tackle understand and evaluate the key drivers of a firm, its
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financial statements and ask questions based on those
A Guide to
ACCOUNTING FOR FUN AND PROFIT

POLICIES BUILT statements.
Understanding

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Lawrence A. Weiss
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business issues to every bankruptcy reform, and has served as an expert witness
student and faculty member. in both civil and criminal cases. His academic articles
have been cited over 1,000 times. He has two prior books:
Corporate Bankruptcy: Economic and Legal Perspectives and
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Financial Accounting and Auditing
Collection
Mark S. Bettner and Michael P. Coyne, Editors
Accounting for Fun
and Profit
Accounting for Fun
and Profit
A Guide to Understanding
Financial Statements
Lawrence A. Weiss
Accounting For Fun and Profit: A Guide to Understanding Financial
Statements
Copyright © Lawrence A. Weiss, 2016
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Dedication
For Marilyn, Josh, and Dan
Abstract
Accounting is an economic information system, and can be thought of
as the language of business. Accounting principles cannot be discovered;
they are created, developed, or decreed and are supported or justified
by intuition, authority, and acceptability. Managers have alternatives in
their accounting choices; the decisions are political, and trade-offs will
be made. Accounting information provides individuals, both inside and
outside a firm, with a starting point to understand and evaluate the key
drivers of a firm, its financial position, and performance. If you are man-
aging a firm, investing in a firm, lending to a firm, or even working for
a firm, you should be able to read the firm’s financial statements and ask
questions based on those statements.This book explains the fundamentals
of financial statements. It is designed and meant to explain the language
of accounting to nonaccountants (i.e., those who hire accountants). After
reading this book, you should be able to pick up an annual report, read it,
understand much of it, and have a solid foundation to start asking ques-
tions about the firm. Hopefully, this book will show you that accounting
can be fun and informative.
Keywords
Accounting, economic drivers of a firm, financial statements, financial
analysis
Contents
Acknowledgments....................................................................................xi
Preface��xiii
Chapter 1 Introduction......................................................................1
Chapter 2 Accounting is Not Economic Reality................................15
Chapter 3 The Accounting Process...................................................27
Chapter 4 Accrual Accounting..........................................................49
Chapter 5 Current Assets..................................................................59
Chapter 6 Long-Term Assets.............................................................87
Chapter 7 Current Liabilities............................................................97
Chapter 8 The Time Value of Money: Discounting
and Net Present Values...................................................111
Chapter 9 Long-Term Debt............................................................127
Chapter 10 Owners’ Equity..............................................................143
Chapter 11 Cash is King...................................................................153
Chapter 12 Financial Statement Analysis..........................................177
Index..................................................................................................189
Acknowledgments
I am grateful to Bridgette Hayes and Stephanie Landers, who corrected
my many editorial mistakes and helped make my prose easier to read.
I would also like to thank Michael Duh for helping to ensure the numbers
are consistent.
A special thanks is also owed to Prof. Mark Bettner for his editorial
comments as well as Scott Isenberg and the team at Business Expert Press.
Finally, I would like to thank my former teachers for setting me on
my academic path and all my former students who have made my career
such a pleasure.
Preface
If you were building a house, would you hire an architect, give her some
money and say, “Build me a house?” If you did, the house might end up on
the front cover of an architectural magazine, but it might not be a house
you would want to live in. I suggest you might benefit from learning a bit
about architecture before building a house so that you could work with
the architect to build the house you want to live in. Similarly, if a surgeon
(who is paid to cut people open, who enjoys cutting people open, and
who honestly believes she can best cure people by cutting them open)
suggests an operation, you would be smart to learn about your illness and
get a second opinion before having the surgery.
Accounting is no different, and it is much too important to be left to
the accountants. If there is one message you should take away from this
book, it is NEVER TRUST AN ACCOUNTANT! This may seem a bit
harsh, but why would you trust an accountant any more than an architect,
doctor, or other professional? A healthy dose of skepticism is a good thing.
Any time you hire a professional, it is best to have a basic understanding
of what the professional does so you can tell the professional what you
want them to do. If you have a medical condition that might require sur-
gery, know enough about your condition to determine whether surgery
is the right course of action and, if it is, to find the best surgeon for you
(not a good idea to try doing surgery on yourself!). Likewise, if you are
managing a firm, investing in a firm, lending to a firm, or even working
for a firm, you should be able to read the firm’s financial statements and
ask questions based on those statements.
This book explains the fundamentals of financial statements. Many
accountants would benefit from reading this book as it may help them
better understand why they are doing what they do, and improve their
ability to explain accounting to others. However, the book is not designed
for accountants. It is designed and meant for those who use and provide
accounting information (i.e., those who hire accountants).
xiv PREFACE
The book takes the perspective of a user of financial information and

therefore limits its coverage of some of the technical aspects (some of
the details can be left for the professionals). This means that many of
this book’s topics are aimed at understanding what an accountant means
when she uses certain terms and what the limits to accounting are. Some
parts of the book are still a bit technical, but they are included because
learning the basics of accounting is like learning vocabulary and grammar
in a language. After all, accounting is a type of language: it is the language
of business.
After reading this book, you should be able to pick up an annual re-
port, read it, understand much of it, and have a solid foundation to start
asking questions about the firm. Moreover, if there is something you do
not understand, seek out an accountant and ask. There are accountants in
all organizations and they generally welcome questions. If the accountant
cannot answer your question, it means one of two things: One, there is a
problem in the financial statements if the firm is presenting material in a
manner that even an accountant cannot understand. Two, it means you
need to find another accountant (as with all professionals, some are better
than others).
Hopefully this book will show you that accounting can be fun and
informative, or at least that it is not as painful as you may fear.
CHAPTER 1
Introduction
Accounting is about communication. It is an economic information

system and can be thought of as the language of business. Accounting
standards are as much a product of political action as they are of careful
logic or empirical findings. Accounting principles cannot be discovered;
they are created, developed, or decreed and are supported or justified
by intuition, authority, and acceptability. This is important to note, as
accounting rules may or may not have any inherent logic to them. We
have alternatives in our accounting choices; the decisions are political and
trade-offs will be made. However, if a user of accounting information
understands the economic consequences of each choice, she can base her
own accounting choices on her desired outcome and also interpret the
decisions made by others.
Accounting information provides individuals, both inside and outside
a firm, with a starting point to understand and evaluate the key drivers of
a firm, its financial position and performance. This information can then
be used to enhance decisions as well as help predict a firm’s future cash
flows. The present “current” value of those cash flows provides an estimate
for the value of the firm. Accounting systems and information are also re-
quired for business and legal reasons. It is therefore essential for managers,
investors, and others to be aware of the signals given and received by the
business community through financial reports.
Who has access to an organization’s accounting information? It depends
on the nature of the organization. For-profit firms can be public or pri-
vate. A firm goes “public” when its ownership units “shares” can be ex-
changed “traded” in a public capital market (e.g., the New York Stock
Exchange). Public firms are much more heavily regulated by the govern-
ment and must provide a prescribed set of accounting information to the
2 ACCOUNTING FOR FUN AND PROFIT
government and the general public.1 By contrast, private firms do not

have to disclose their accounting information to the general public.2
Not-for-profit organizations (charities, churches, private universities,
and so on) must file a set of specified information to the government that
is made public.
Who (or what group) is responsible for issuing an organization’s annual
report? Senior management.
Who (or what group) is the annual report for? There are lots of different
potential users including:
• Owners, both current (those who actually own a piece or

share of the firm) and potential (those who are thinking about
buying a piece or share of the firm),
• Suppliers of goods, services, and funds. Individuals and other
firms who do something for the firm and expect, at some point,
to receive something (usually cash) from the firm. This includes
both current and potential employees (i.e., suppliers of labor),
• Customers (who purchase the firm’s goods and services),
• The government, both in the sense of taxes (getting money
from the firm) but also in terms of regulation, since
government regulators are supposed to ensure the firm
operates and reports according to the law, and
• Various other outside groups, including accounting professors
(who will use the firm’s reports in class), reporters (who may use
the firm’s reports in a story), environmental groups, and so on.
In sum, senior management publishes annual reports for various users.
1
The government actually gets two sets of financial data. One is the tax information
which all firms must provide to the Internal Revenue Service (IRS) and is not publicly
available. The other is the public financial information that the firm provides to the
Security and Exchange Commission (SEC) which then posts it on an electronic site
called EDGAR. See www.sec.gov/edgar.shtml
2
The vast majority of firms are private, and most of these are owner managed (mean-
ing the firms’ owners are also the managers). However, there are some very large firms
which are private. For example, Mars Corporation (the large confectionary firm with
brands such as M&M’s) is a private company and its accounting information is not
available to the general public.
INTRODUCTION
3
What is this report about? What is it meant to tell the users? It is designed
to give the users identified above information about the firm’s economic
resources, how it obtained those resources, who has claims on the re-
sources, what the firm has done with those resources, and how they have
changed over time. It is designed and meant for users who have some
understanding of basic business, economics, and accounting.
How are these various groups going to use this information? The informa-
tion should be used as a starting point in trying to estimate the timing,
likelihood, and amount of future cash flows. Why? So they can assess a
firm’s financial health and make better informed decisions (i.e., invest in
the firm, sell to the firm, lend to the firm, buy from the firm, and so on).
Okay, so if senior management is producing this information for a va-
riety of users, it means management is basically providing outsiders with
information about the senior management’s activities. Is that right? Yes,
it is like a student (as opposed to a teacher) producing the report card on
how well she did. Are there any checks to make sure what management says is
true? Actually, there are not many checks we can use for this. A ccounting
has limitations; it is not, in any sense of the word, trustworthy (more on
this in Chapter 2) and it provides limited supervision of senior manage-
ment. This is why it is critical for anyone using the information in finan-
cial statements to understand how the information is prepared.
Consider, if you were senior management, what would you want to say?
Well, that depends on whom your message is for.
What does senior management normally tell the owners? It is not uncom-
mon for them to report, “I am great. You could not have a better manager.
It is true we lost a lot of money this year, but anyone else would have lost
much more. You are lucky to have us, and there is no question you should
keep us as your senior management.” Normally, management wants to
keep their jobs, and they therefore tell the owners they are doing a good,
if not great, job. However, “normally” does not mean always.
What if senior management itself wants to buy the firm from the
non-management owners? Imagine you are managing a firm you inherited
from your parents. You are working hard and doing your best, but you
do not own the firm outright. You have some siblings who also own part
of the firm, and they do not help at all. They do not pull their fair share,
yet they still demand money from the firm. Because of this, you want to
buy them out. What would you tell them? You could say the firm is doing
great. Or you could say that the firm is barely making it and that while it
is really worth next to nothing, you still want to buy it from them and will
pay them some minor amount for their shares. When reading a financial
statement, you need to know not just to whom management is talking to,
but also what senior management’s bias is. Does senior management want
to make the firm look good or bad? It depends on their bias.
What does management normally want to tell bankers and the people or
companies who sell goods and services to the firm? Typically, management
wants to tell these readers not to worry because the firm will pay what it
owes (i.e., repay loans to the banks or pay suppliers for services rendered
or goods provided).
What does management want to tell the firm’s employees? We are doing
okay but not great, so the firm is unable to give raises this year, but em-
ployees’ jobs are secure and they do not need to look for other ones. Note
that we have a potential conflict here. Management may want to tell the
owners they are doing great, but tell the employees the firm is doing okay.
How about the customers? What does management want to tell them?
Again, management wants to tell them that the firm is doing okay, that
it will be around to supply them next year, but that it is not doing well
enough to give any discounts.
What about the government? Well, the primary governmental entity
looking at firm’s financial information is the Internal Revenue Service
(IRS). To this group, management probably wants to show minimal
profits saying that it does not have much to give to the government this
year. Maybe in a few years when the firm is doing better, the government
can ask for something.
Notice that what management wants to tell the government is pretty
much the exact opposite of what they normally want to tell the firm’s own-
ers. The good news for management today is that in most countries, firms
are allowed to produce two sets of financial statements: one for the govern-
ment (which is private and intended to be read only by the government’s
taxing authorities) and another for everyone else. So to some extent, man-
agement can plead poverty to the government, while telling others they
are doing well. It may seem hard to believe that there are two sets of finan-
cial statement reporting about the same firm’s performance in the same
INTRODUCTION 5
year, but it is what happens. Management can make different accounting

choices and their decision to do so may depend on whether their report
is going to the government or to everyone else. Over time the cumulative
numbers will match, but in a given year they may be very different.
Think of the annual report as a public relations tool. Better yet, think
of it as a painting. Accounting is an art: it really is much closer to art, or
perhaps to the legal profession, than it is to math or science. Management
is painting a picture of the firm. Management may try to paint like Rem-
brandt and give you a picture that illustrates fairly transparently what the
firm looks like (you look at the painting and know what the author was
painting). However, management may paint more like Picasso. My Dad
loved Picasso, but I have never understood him (the painter, not my Dad).
Still, I have read that Picasso painted his mistresses, who I have seen in pho-
tos and who were beautiful (at least superficially). So, even though when I
look at a Picasso painting that is supposedly of a female but to me it does
not look human, I know the person being painted was physically beautiful.
In accounting, like art, it helps to know something about the composer.
For fun: Can you identify what firm produced the Annual Report covers
in Exhibit 1.1?
(A) (B)
(C)
Exhibit 1.1 What firm produced these covers?

They are for the wine and spirits firm Pernod Ricard whose 37
premium brands include Absolut, Chivas, Glenlivet, G.H. Mumm
Champagne, and Kahlua among many others (the reports shown are for
the years ending 2006, 2010, and 2015). I am not really sure how they
relate to the financials, but clearly they have an artistic bend.
By contrast, the report covers in Exhibit 1.2, for Boeing, reveals its
products by showing them on the covers. Boeing is saying “this is who we
are and what we do.”
Most firms no longer have fancy covers. They simply have the in-
formation required by the government (see www.sec.gov/edgar.shtml)
and maybe the firm’s logo. Exhibit 1.3 shows the cover for Apple Inc.
The covers of annual reports tell you something about the firms that
published them. It is like getting dressed in the morning: What you wear
Exhibit 1.2 Boeing Annual Report covers 2012 to 2014

INTRODUCTION
7
Exhibit 1.3 Apple Inc. Annual Report cover 2015
tells the world not only something about you but also something about
what you want the world to think about you.
And that is what the annual report is meant to do. It is senior manage-
ment telling the world something about the firm and what senior man-
agement wants the world to think about the firm.
So, let us open the cover and take a look at what is inside.
Inside an Annual Report

The annual report usually begins with a summary or the highlights of the
firm’s results for the year (and usually some prior years) being reviewed.
This is generally followed by a letter from the Chief Executive Officer
(CEO) of the firm (and sometimes from the chairman of the board as
well). This letter should be read carefully, as it outlines the CEO’s view
of what happened and where the firm is heading. It often includes an
overview of the firm’s strategy, and generally thanks the investors and
employees. It should be read as a political statement and a piece of public
relations, which is what it is. Still, it can contain valuable information
about what the head of the organization is thinking.
Though the exact ordering can differ, the CEO’s letter is usually
followed by lots of information on the firm’s products (e.g., what they
are, how they are being developed, perhaps even how they compare
to those of major competitors). This provides background not only of
the firm’s products, but often on the industry and general economy as
well. Again, this should be viewed with a great deal of skepticism as the
firm is usually trying to present its products and markets in the best
possible light.
Next up is normally a brief review of the firm’s major accounting poli-
cies, some of which will be discussed in more detail later in the book. It is
very important to read the accounting policies as they set the context for
the accounting numbers.
Then, somewhere in the middle of the annual report comes the main
dish: the financial statements. These are the Balance Sheet, the Income
Statement, and the Statement of Cash Flows.3 All three will be discussed
in greater detail in the coming chapters.
The financial statements are followed by the Notes to the Financial
Statements, which provide details on all the accounting choices that
were made when preparing the annual report. The financial statements
3
There is also sometimes a Statement of Changes in Retained Earnings (which is fairly
straight forward), a Statement of Changes in Equity (which can be more complex),
and a Comprehensive Income Statement (which includes all components of net in-
come/loss and other comprehensive income/loss).
INTRODUCTION
9
present an overview or summary, whereas the notes contain much more

detail.
Somewhere near the end of the financial statements is The Report of
the Independent Auditor. The firm hires and pays an outside group of
professionals to examine its financial statements and issue an opinion on
their reasonableness. Wait. How can the outside professionals be considered
“independent” if they are hired and paid by the firm on which they are report-
ing? Good question, and many people would argue that the auditors are
not completely independent (Enron is a case in point). However, there are
three counterpoints to this argument. First, these professionals are in fact
hired by a subset of the board of directors who are supposed to be totally
separate from management. Second, auditors report to the board and not
to the management. Third, and this one is key, the auditors can be sued if
they do not do their job properly, especially by the firm’s owners, who the
auditors technically report to.
There are four companies today known as the “big four” that audit
most of the larger public firms (Deloitte, Ernst and Young, KPMG,
and PricewaterhouseCoopers). These are large accounting firms and
they provide an array of accounting, auditing, tax, legal, and consulting
services. They are perhaps the largest service firms in the world and are
substantially larger than the largest consulting firm (in 2015, Deloitte
listed $16 billion of U.S. revenues and 70,000 professionals, whereas
McKinsey and Company listed 11,000 professionals). The group was
once known as the “big eight” but mergers and the demise of Enron’s
auditor (Arthur Andersen) reduced the group to four. These are interna-
tional companies, with the size and expertise to audit the largest public
firms. Also, these firms have substantial resources and could pay out
large sums if they lost a lawsuit. Arguably, what keeps these firms honest
(independent) is that for many of the senior partners their most valu-
able asset is their ownership unit in their accounting firm. In theory,
any one senior partner who fails to do her job properly could expose
the firm to massive litigation (Arthur Andersen, the audit firm hired by
Enron, collapsed largely because of its misconduct in auditing Enron).
To counter this possibility, these firms set up their own internal systems
(with a central group auditing the auditors) to ensure their work is done
properly, at least in theory. The Sarbanes–Oxley Act (enacted in July
2002) has also done a great deal to increase auditor independence both
with increased oversight (and the creation of the Public Company Ac-
counting Oversight Board) and by limiting a uditor conflicts of interest
(e.g., the nature and extent of non-audit work done by auditors has been
greatly reduced).
So, if a firm has a good audit report can the numbers be trusted? NO!
ABSOLUTELY NOT! The auditor only expresses an “opinion” on the
“fairness” of the financial statements.4 First, the auditor is supposed to as-
sess whether the statements reasonably portray the underlying economics
within the accounting framework. However, reasonableness or fairness is
subject to interpretation, often a court of law’s interpretation. Users of
annual reports should interpret an auditor saying the numbers are rea-
sonable as the auditor saying they are close enough that she is not overly
worried about being sued. Second, the auditor does not check everything
because that would be much too time consuming, which would delay the
annual reports and make the information they contain less useful, and
would also be prohibitively expensive. Third, it is possible for the auditor
to make a good faith effort, do her job responsibly and professionally, and
still fail to discover a major error or fraud. Finally, if the auditor feels the
statements are not reasonable, she will probably enter into a negotiation
with management to change the numbers prior to publication to avoid
having to release a negative audit report.
Does that mean the audit report is basically useless? Not at all. In fact, the
report can be quite informative and useful, especially as a starting point.
Let me explain by describing the various types of audit reports and what
each means.
The first and most common is called an unqualified or clean report.
Here the auditor says he was able to do his work, and that the statements
appear reasonable and in conformity with generally accepted accounting
principles (GAAP) applied consistently over time, the auditor did not
find any material misstatements and there is no evidence suggesting that
4
In some countries, this opinion is set up as certifying the statements are true and
correct. Unfortunately, this is far from what is really done by the audit.
INTRODUCTION
11
the firm is not a viable going concern.5 This is what you should expect,
and you would then go into the statements and notes with a normal de-
gree of skepticism (i.e., caveat emptor).
The second and less common is called a qualified report. Here the
auditor notes there is something that the reader should know. Although
the auditor finds the numbers are reasonable overall, there was something
that the auditor could not examine or determine. If the auditor was hired
after the start of the year, this means the auditor would not have been
able to check last year’s number herself at the end of last year. The a uditor
would point this out and note she is relying on the previous auditor. This
begs the question: Why did the firm change auditors? 6 A positive explana-
tion is the firm was growing and the prior auditor was too small to con-
tinue auditing the growing firm. Investors and creditors may appreciate
that the new auditor is larger, hopefully has more expertise, and with its
increased size should be able to pay out a larger sum in the event of a
lawsuit. A change may also occur when one firm acquires another firm
of equal or greater size and the auditor of the acquired firm becomes the
auditor of the combined firm. There could also have been a change for
certain expertise. The financial statement user should carefully consider
whether the change in auditor was for a legitimate reason or whether the
change occurred because the prior auditor was unwilling to express a posi-
tive opinion on the statements.
The auditor may note that the statements appear reasonable overall but
that there is an overriding issue which could not be determined and could
alter the economics of the firm. For example, the firm may be subject to a
lawsuit that the auditor cannot determine if the firm is likely to win or lose,
and the amount is large enough to potentially alter the firm’s financials.
5
GAAP refers to the guidelines (rules and practices). In the U.S., they are set out by
the Financial Accounting Standards Board (FASB), whereas many other countries fol-
low those set out by the International Financial Standards Board whose guidelines are
referred to as International Financial Reporting Standards (IFRS).
6
There is a movement to force a change of auditors every few years, but the change is
in fact very expensive as auditors develop expertise with their clients. Most financial
institutions, which are considered critical to the economy, require periodic changes
in auditors.
The auditor may also note that the statements appear to be reason-
able overall but that there has been a major change in an accounting
method. As will be discussed in detail in the coming chapters, firms have
many choices over accounting policies and these choices alter the final
numbers. Changing policies is allowed, but in the year of the change,
numbers must be presented using both the old and the new method and
the annual report must explain the reason for the change. Some changes
are managerial choices, others are dictated by the government. Regardless
of whether the firm made the change voluntarily or after being forced by
the government, major policy changes are considered so important that
they will be noted in the auditors’ report.
The third and fairly rare type of audit report is called a disclaimer or
denial of opinion. In this case the auditor notes that he was unable to
perform his work and cannot express an opinion on the financial state-
ments. For instance, this can occur after a fire that destroyed factory
records, or perhaps when there is a strike and the auditor cannot access
the records.
Finally, the rarest form of opinion is called an adverse opinion. In
this case, the auditor expressly notes that the statements are not reason-
able (e.g., they do not fairly reflect the firm’s economic condition). This
can occur when a firm is in financial distress and likely to be liquidated
(when a firm is not considered a going concern all the numbers must be
at liquidation value), or if the auditor fundamentally disagrees with the
firm’s financial presentation. The latter is very rare because either (a) the
auditor and firm will negotiate some changes in the numbers to enable
the auditor to express at least a qualified opinion, (b) the auditor will be
replaced, or (c) the opinion will simply not be issued.7
In Which Order Should Annual Reports be Read?

The best place to begin reading an annual report is with the auditor’s
report at the end. This will usually tell the reader nothing, since it is
normally a clean audit report. However, if there is an issue, it will alert
7
For example, firms entering bankruptcy often do not issue timely financial statements
and thus there is no opinion.
INTRODUCTION
13
the reader at the start. Next the reader should examine the Notes to the
Financial Statements, as they put the statements into context. The state-
ments themselves should be read next. All the puffery and the CEO’s
letter at the front can be examined last. At least, this is how your author
reads an annual report.
How to Read this Book

This book can be read by someone with little or no business background.
It is a primer on the basics of accounting, what accountants do, and how
to interpret the information in financial statements.
The book is written in a conversational format, often asking ques-
tions (which, as you may have already noticed, are in italics) and then
providing the answers. The reader may want to pause after a question and
think how they would answer before reading on. Real-life examples are
included to illustrate the concepts and hopefully make the subject matter
more interesting.
The footnotes do not have to be read, but they are meant to be read
and add important details.8 After reading the book, you will hopefully
have enjoyed yourself and learned a lot about accounting. Welcome
aboard.
The Bottom Line

Accounting is an economic information system, it can be thought of as
the language of business, and understanding its process, uses, and limita-
tions is essential to understand the economics of a firm.
The following chapter describes the underlying nature of accounting
and illustrates the necessary trade-offs that limit the ability of accounting
to reflect a firm’s underlying economic reality. There are many “truths” in
accounting.
8
I have tried to make this book fun while also paying attention to the details.
CHAPTER 2
Accounting is Not Economic

Reality1
This chapter describes the underlying nature of accounting and illustrates

the necessary trade-offs that limit the ability of accounting to reflect a
firm’s underlying economic reality.
There is a perception that accounting numbers present the truth. This
probably stems from accounting’s mathematical basis. The Balance Sheet
presents a firm’s assets (what it owns) and how it financed the assets (by
borrowing-called liabilities or from the owners-called owners’ equity).
Why does a Balance Sheet have to balance? Ask this question to an ac-
countant and you are likely to be told that the Balance Sheet is simply the
mathematical equation:
Assets = Liabilities + Equity
If you press the accountant further, you will be told about the com-
ponents of the Balance Sheet and how it is produced (with a high chance
you will also be told all about the use of Debits, which means to the left,
and Credits, which means to the right—more on this in Chapter 3). The
accountant will say that if a Balance Sheet does not balance, it means a
mistake has been made. While true, this view misses what the Balance
Sheet is really about.
The Balance Sheet must balance because on one side it reflects the re-
sources that a firm owns and controls and that will provide the firm with
future cash flows (the Assets), and on the other side, how those resources
1
This chapter is also an appendix in Asquith and Weiss, Lessons in Finance © 2016.
Reprinted with permission.
are financed (the Liabilities and Equity). Each side is measured separately,
and the two sides must balance. If they are not equal, it means a mistake
has been made, which must then be found and corrected (if they are
equal, however, it does not mean the Balance Sheet is free of mistakes). A
Balance Sheet is seen in Exhibit 2.1 using a large T with the Assets on the
left and the Liabilities and Equity on the right (again the details will be
discussed in the coming chapters).
Thus, the Balance Sheet is an algebraic equation. However, the truth
is that accounting is closer to an art, or a language (the language of busi-
ness), than a science. The accounting numbers present one of many pic-
tures of the underlying economics of a firm—but there is no single truth
to present. Why? Because accounting rules and practices provide manag-
ers with discretion over how they present the economic reality of a firm.
Let us use an example to illustrate the many different accounting
“truths.” Consider a simple business venture: selling T-shirts. For sim-
plicity, the owner/investor puts in $36 (meaning both the firm’s cash and
the owner’s equity account increased by $36). Over time, the owner pur-
chases three identical T-shirts for $10, $12, and $14, meaning a total of
$36 from cash is spent and T-shirt inventory increases by $36. Note, this
example involves a change in purchase prices. It does not really matter
why the price changes (inflation, market conditions, and so on). Since,
as stated, the T-shirts are identical, a customer will not care which one
he is given. Before anything has been sold, the Balance Sheet will bal-
ance with $36 in T-shirt inventory and $36 in owner’s equity as shown
in Exhibit 2.2.
Exhibit 2.1
A simplified Balance Sheet
Assets: Liabilities:
Cash Payables (owed to suppliers)
Receivables (owed to the firm) Borrowed funds
Inventory
Other short-term resources Equity:
Property, plant, and equipment Capital received from owners
Other long-term resources Retained earnings (profits earned and kept)
Accounting is Not Economic Reality 17
Exhibit 2.2
The Balance Sheet before any sales
T-shirt #1 $10 Amount borrowed $ 0
T-shirt #2 $12
T-shirt #3 $14 Equity:
Capital from owners $36
Total $36 Total $36
Now assume the business sells one T-shirt for $20. How much profit
has the business made by selling one T-shirt? Write down your answer and
then read the possible accounting choices below.
There are five possible methods to answer this question:
1. Inventory reported using the First-In First-Out method,

2. Inventory reported using the Average method,
3. Inventory reported using the Last-In First-Out method,
4. Cash accounting, or
5. Inventory valued at its market value.
The first three are traditional accounting methods based on how the
firm decides to value “cost” the dollar amount of the one T-shirt sold,
which is then subtracted from the selling price. If the firm chooses to do
so in the same order they were purchased, then they would be costing
the oldest unit first. This method is called “first-in first-out” (FIFO) and
would result in the firm having a profit of $10 ($20 in revenue − $10 in
cost). Note that this leaves the most recently purchased T-shirts (the last
two T-shirts) on the Balance Sheet as assets with a value of $26 as shown
in Exhibit 2.3.
It is also possible to report the inventory by computing an average
cost for the three T-shirts ($36/3 = $12). This method is called “average”
(AVG) and produces a profit of $8 ($20 in revenue − $12 in cost). Note
that this will value the two remaining T-shirts at $12 each for a total of
$24 in inventory as shown in Exhibit 2.4.
Exhibit 2.3
First-In First-Out
Cash $20 Amount borrowed $ 0
T-shirt #2 $12
Profit $10
Total $46 Total $46
Exhibit 2.4
Average
2 T-shirts @ $12 = $24
Equity:
Profit $8
Total $44 Total $44
A third option is to cost the unit of inventory sold by using the most
recent purchase price. This method is called “last-in first-out” (LIFO) and
it produces a profit of $6 ($20 in revenue − $14 in cost). Note that this
leaves the earliest purchased T-shirts (the first two) in the Balance Sheet
as assets with a value of $22 (the first at $10, the second at $12) as shown
in Exhibit 2.5.
Thus, three different methods (FIFO, AVG, and LIFO), all of which
are correct, results in three different profit amounts and three different
Balance Sheets.
An argument in favor of FIFO is that the two units of unsold inven-
tory on the Balance Sheet would be valued at $26 ($12 + $14), which
is probably closer to a replacement cost of $28 (assuming prices have
Exhibit 2.5
Last-In First-Out
T-shirt #1 $10
Profit $6
Total $42 Total $42
increased to $14, replacing the two units would probably mean paying
the last purchase price of $14 for each one). In contrast, the inventory
value computed under LIFO is much lower than the potential replace-
ment cost: LIFO would value the remaining inventory at $22 ($10 +
$12). Thus, by using FIFO and using the value of (costing) the oldest unit
first, the Balance Sheet is more reflective of the current underlying value
(i.e., replacement cost) of inventory. The inventory number under FIFO
is probably more relevant, in terms of the Balance Sheet, than the number
under LIFO.
So why is FIFO not mandated for all financial statement disclosures? The
reason lies in the fact that firms’ equity values are not based strictly on the
numbers on a Balance Sheet. Most firms are valued based on their ability
to generate profits in the future. A key objective in financial reporting is
to provide outsiders with an ability to estimate the future cash flows of a
firm, and this is done by starting with an examination of the accounting
profits (we predict the future by starting with the past). For this, the out-
siders use not only the Balance Sheet but also the Income Statement and
the Statement of Cash Flows (all coming attractions).
Although FIFO may provide a more relevant valuation of inventory
on the Balance Sheet, the profit generated using FIFO is $10 ($20 in
revenue less $10 representing the FIFO cost of the T-shirt that was sold).
The profit generated using LIFO is $6 ($20 in revenue less $14 represent-
ing the LIFO cost of the T-shirt that was sold). Which of these two profit
numbers is a better predictor of future profits and cash flows? If the selling
price remains at $20 and the purchase of new T-shirts stays at $14, then
the $6 computed under LIFO is a better estimate of expected profits going
forward. The $4 difference in profits ($10 − $6) will eventually be realized
when the firm sells off its inventory. The extra profit on the first and sec-
ond T-shirts, for which the firm paid $10 and $12 is not sustainable, and
thus LIFO may provide a better estimate of future profits and cash flows.
The average method is a compromise between the two.
Why not simply number the three T-shirts and cost the one which is actu-
ally sold? This is a valid method called specific identification and is used
in high-value products where customers choose the specific product sold
(e.g., automobiles). However, in the example being given, the T-shirts are
of low value and identical. Costing the actual T-shirt sold would allow
management to choose the profit they will report by choosing which
T-shirt they give the customer (the customer would not care, as they
are identical). A key goal of accounting is to set up a process preventing
management from simply choosing the profit it reports to outsiders.
It is true that by being able to choose the accounting method to use—
FIFO, LIFO, and AVG—management can also alter a firm’s profit. How-
ever, because firms must disclose their accounting choice, an outsider can
interpret the profit number accordingly (and/or adjust it to reflect an
alternative choice).2
These three traditional accounting methods—FIFO, LIFO, and
AVG—demonstrate the trade-off being made between focusing on a Bal-
ance Sheet and wanting those values closer to economic reality (i.e., what
the assets are worth and how they were financed) or focusing on an In-
come Statement (the difference in selling price and costs, used to estimate
future cash flows). But there are two other possible methods to compute
the profit made by this simplified business venture.
Another approach is to focus on cash. As we will see later when we
discuss cash flows, reality is cash (or alternatively “Cash is King”). How
much cash came in, and how much cash went out? Using cash accounting,
2
Firms are allowed to change their accounting choice. However, they must state the
reason for the change and in the year of the change provide information using both
the old and new accounting methods.
Exhibit 2.6
Cash basis of accounting
Equity:
Loss ($16)
Total $20 Total $20
there is only one asset category: cash.3 Costs are incurred when cash is
paid and revenue occurs when cash is received. Thus, if the only asset
recorded is cash (which is what cash accounting does), then the firm will
have a loss of $16 after the sale of one T-shirt (the initial $36 outlay plus
the $20 from the first sale) as shown in Exhibit 2.6.
The benefit of the cash basis of accounting is that it reflects one ele-
ment of reality: the actual flow of cash in and out of an organization. The
limitation of this basis of accounting is that it fails to value the remaining
inventory or provide any ability to predict future cash flows.
Finally, another option is an economic concept of accounting called
fair value reporting. This approach values the remaining T-shirts not at
their cost but at an estimate of their market value. The T-shirts would be
valued at their market value, the price established by the last sale ($20
each).4 The firm’s profit is computed as the difference in value from the
start to the end of the year as shown in Exhibit 2.7.
Thus, the firm began with an economic value of $36 (the cash in-
vested by the owners) and ended with an economic value of $60 ($20
3
Cash accounting (in contrast to the more commonly used accrual accounting) is
often used by farmers, fishermen, and some small businesses. It is also sometimes used
for tax purposes.
4
Other profit numbers are possible. For example, using the last purchase price of $14
instead of the most recent selling price of $20 to value the two units of ending inven-
tory, which would yield a final Balance Sheet of $48 ($20 cash and 2 × $14 = $28 in
inventory) and a profit of $12 (a $36 starting value vs. $48 ending value).
Exhibit 2.7
Fair value
2 T-shirts at $20 = $40
Equity:
Profit $24
Total $60 Total $60
cash and T-shirt inventory valued at $40). The difference between the
opening ($36) and closing firm value ($60) is the profit, real, and po-
tential, of $24. Fair value accounting reflects the fact that if we were to
sell our T-shirt business to someone else, with assets of $20 cash and two
T-shirts worth $20 each, we would be looking for a price of $60.
Fair value accounting attempts to overcome an element not corrected
by the other accounting methods: management’s discretion over the ac-
counting process. One benefit of fair value accounting is that the value
will be the same regardless of how many units are sold or in what order.
The problem with fair value accounting is that it still provides manage-
ment with discretion to influence the process by choosing how to value
the unsold inventory. The true economic value of the inventory (or what-
ever is being valued) is the relevant (i.e., useful to outsiders) number.
However, if there is no active liquid market for the item being valued,
then a management-determined number, which may not be objective,
must be used.5
Note: The choice of how to cost the inventory (FIFO, LIFO, AVG,
and so on) or of whether to use cash accounting or fair value is not re-
quired if the accounting is only done after all three T-shirts are sold. If
firms only did their accounting when the business was being liquidated,
5
A liquid market is one where assets can be sold quickly at a fair price.
all these accounting choices would give the same results.6 Thus, it is only
because we do accounting every year (or month or quarter) that we are
required to make these choices.
The Bottom Line

These examples, from a simple business venture, demonstrate why there
is no single truth in accounting. Accounting faces a trade-off between
providing the best valuation of the assets vs. providing the best basis for
estimating future cash flows. The manager decides based on the picture
of the firm she wants to present to outsiders. As the business venture be-
comes more complex, so does the impact of these trade-offs. This is why
there is no single way to determine the one “profit” number or “net value”
in accounting. To understand the underlying economics of a business, the
financial statements must be viewed in their totality as a starting point
and not an end point and it is critical to know the accounting choices
that were made.
The next chapter provides an explanation of how the accounting pro-
cess works—the details of what accountants do behind the numbers. But
first, Appendix 2A presents an important illustrative exposition on ethics
in accounting.
6
Luca Pacioli, the Venetian monk who first wrote down our modern system of ac-
counting, did so for Venetian merchants accounting for shipping expeditions. Goods
were acquired, a boat and sailors were hired. The boat sailed away, goods were traded,
the boat returned, the goods were sold. Then, the profits were distributed. Account-
ing for this type of expedition did not require the timing assumptions. Profits were
not computed per quarter or per year. The profits were computed only at the end of
the enterprise.
APPENDIX 2A
If the Auditors Sign Off,

Does that Make It Okay?
Originally published on HBR.org Tuesday May 1, 2012, by Lawrence Weiss

https://hbr.org/2012/05/if-the-auditors-sign-off-on-it
Andrew Fastow, the former chief financial officer of Enron, recently
completed a six-year prison sentence for his part in the scandalous decep-
tion that hid Enron’s financial troubles from investors. After I was quoted
late last year in an article on the 10th anniversary of the Enron debacle,
Fastow contacted me and offered to speak to the Financial Statement
Accounting class I teach at Tufts University’s Fletcher School of Law and
Diplomacy.
Last month, Fastow made good on his offer. Why did he commit fraud?
Why did a bright, aspiring, stereotypical MBA cross the line and misrepresent
the true financial picture of Enron? According to Fastow, greed, insecurity,
ego, and corporate culture all played a part. But the key was his procliv-
ity to rationalize his actions through a narrow application of “the rules.”
Fastow’s message, an important one for all managers and potential
managers, has two key points. First, the rules provide managers with dis-
cretion to be misleading. Second, individuals are responsible for their ac-
tions and should not justify wrongful actions simply because attorneys,
accountants, or corporate boards provide approval.
After his guilty plea for fraud, Fastow forfeited $23.8 million in cash
and property. He has helped the Enron Trust recover over $27 billion, of
which $6 billion has gone to shareholders. (And he was not compensated
for his presentation to my class.)
He began the presentation by admitting he committed fraud and tak-
ing full responsibility for his actions. He made a heartfelt detailed apology
and expressed remorse for having hurt so many people. He admitted mak-
ing technical violations and taking wrongful actions that, while approved,
APPENDIX
25
were misleading. He said he knew what he was doing was wrong. But he
rationalized those actions in his mind at the time because the result was
higher leverage, a higher return on equity, and a higher stock price. Fur-
ther, he convinced himself that his actions were acceptable because they
had been signed off by the firm’s lawyers, accountants, and board and
were disclosed in the financial reports. He told himself his actions were
systemic, it is the way the game is played. All who cared to know knew.
As Fastow rhetorically asked my students:
“If the internal and external auditors and lawyers sign off on it, does that
make it okay?”
The problem is that attorneys, accountants, managers, boards, and
bankers are not gatekeepers; rather, they are there to help businesses ex-
ecute deals. They are enablers. In the case of Enron, these outside advisers
played an active role in structuring and disclosing the deals, and the board
approved them, but managers were still responsible for their own actions.
Thus, technically following the rules as interpreted by these advisers, even
if theirs is the best expertise money can buy, does not make a given action
“right.” Fastow emphasized that enablers are not an excuse: Each indi-
vidual is his or her own and only gatekeeper.
Fastow suggested that to avoid falling into an ethical trap he should
have asked himself the right questions: Am I only following the rules or am
I following the principles? If this were a private partnership, would I do the
same deal?
Regulation has not prevented fraud. In fact, it may have exacerbated
the problem. Enron viewed the complexity or ambiguity of rules as an
opportunity to game the system.
Compare Enron’s deals with the structured finance innovations
we’ve seen since the passage of the Sarbanes–Oxley Act: Enron’s pre-
pays (circular commodity sales which moved debt off the Balance Sheet
and generated funds flow) look very similar to Lehman’s Repo 105s
(short-term loans secured with a transfer of securities treated as a sale
of securities). The mispriced investments and derivatives at Enron look
similar to mortgage-backed securities at banks or companies with a dis-
proportionate amount of Level 3 fair value assets (illiquid assets with
highly subjective estimated values). Enron’s $35 billion in off-balance
sheet debt looks puny compared to the $1.1 trillion of off-balance sheet
26 APPENDIX
debt at Citi in 2007. Enron did not pay income taxes in four of its last
five years, and GE pays little today. Banks are now engaging in “capital
relief ” deals that inflate regulatory capital in advance of the new Basel
standards. Are these deals true risk transfers or are they cosmetic?
If regulation is not the answer, then how can corporations and society pre-
vent fraud in the future? Fastow said we can begin by understanding that
structured finance is like steroids: A little can cure many illnesses, but a lot
can destroy your organs. Its use needs to be limited, and investments in
firms that use structured vehicles without a clear business reason should
be avoided. Mark-to-market accounting can lead to more transparent fi-
nancial statements but, if abused, can put a company in a hole that it
can’t climb out of. The market must value transparency. Companies with
the fairest disclosures must be rewarded, not placed at a disadvantage as is
now the case. Finally, executives must ask whether a transaction is consis-
tent with the principle and not just the rules. Are they doing it for window
dressing or for valid business purposes?
It is critical for analysts, directors, and managers to maintain a cer-
tain sense of humility and to understand how human nature, competitive
pressures, and a lack of clear guidelines can lead to potentially disastrous
choices. And it is not just corporations that engage in these practices. Yes,
Enron hid debt in derivatives. So did Greece.
CHAPTER 3
The Accounting Process
The first step to learn about accounting is understanding the process of

recording financial information. This process is called bookkeeping and it
is a part of what accountants do. To be able to interpret financial informa-
tion, one must learn the basic vocabulary, concepts, and procedures. After
that comes learning about ratio analysis, which is the relationship of one
accounting number to another, and is used to examine a firm’s competi-
tive position. The individual accounting numbers themselves are only the
starting point.
Account—The Basic Unit of Storage

All organizations maintain a set of accounts (the basic unit of storage) of
everything the organization wants to keep track of. Within an organiza-
tion, this list will be very detailed. For example, a firm will have a sepa-
rate cash account for each place where cash is stored. This means a firm
with a chain of department stores across the country will have a separate
cash account not only for its numerous bank accounts but also for each
cash register. Likewise, a firm with different types of products will have a
separate account for each product in each location. Thus, even a small or-
ganization may have hundreds of accounts, whereas a large one can have
millions. Remember, the organization is using each account to keep track
of something it cares about.
Does a public for-profit firm or charitable organization provide complete
information on all its accounts to the general public? No, the organization will
provide those outside the firm with only a short summary of the accounts.
Why not provide the details? Three reasons: First, those outside the firm do
not want very detailed information. Consider Apple Inc. as an example:
Would a potential investor care about how much Apple Inc. has in cash in each
of its stores, bank accounts, and factories or would they just want to know the
total cash the firm has? The investor would mostly care about the total cash
amount. Additionally, providing information on all of Apple’s accounts
would overwhelm most outsiders (e.g., 10,000 cash accounts translates to
250 pages at 40 lines a page). Second, it is not cost effective for an orga-
nization to provide all its detailed accounting information to the general
public. Third, most organizations do not want to reveal specific details of
their operations to their competitors, who are able to access any informa-
tion made available to the general public. Thus, although Apple needs to
keep track of each individual cash account, outsiders are only provided
with a total amount and probably do not need more than that.
If organizations do not provide all of their accounting information, what
information do they provide? As explained in more detail below, public or-
ganizations provide certain financial statements along with explanations
(notes) detailing their accounting choices, estimates, and assumptions.
The Balance Sheet

The Balance Sheet indicates the resources a firm has and how it is fi-
nanced. It contains a summary list of certain accounts that are considered
“permanent” accounts, as they are cumulative over time and represent the
account balance as at an instant in time. The Balance Sheet represents the
basic accounting equation:
Assets = Liabilities + Owners’ Equity1
Assets are resources the firm owns or controls that will provide some
future economic benefit to the firm based on a past transaction or event.
(It may be useful to read the prior sentence a few times.) Assets are sepa-
rated into current assets (those which will be used or converted to cash
usually within 1 year) and long-term assets.
1
The Balance Sheet’s name is usually thought to derive from the requirement of the
left side (Assets) equal, or balance, with the right side (Liabilities and Equity). How-
ever, it can also be argued that the name derives from the listing of the ending values
or “balances” in the accounts.
The Accounting Process 29
Liabilities represent future economic sacrifices of goods (including

cash) or services required because of a past transaction. In other words, lia-
bilities are monies, products or services that are owed to other organizations,
people or the government. Like assets, liabilities are also divided into current
(those which will be provided within 1 year) and long-term liabilities.
Finally, Owners’ Equity is comprised of funds the owners have con-
tributed to the firm. This is composed of two parts: Contributed capital
is the amount the owners gave the firm. Retained earnings are the cu-
mulative profit or loss a firm made from its inception to the date of the
Balance Sheet minus any funds given to the owners (these funds given to
the owners are called dividends). Retained earnings are profits a firm has
kept to fund resources. Many people view owners’ equity as being the
balancing figure, and it is often referred to as net assets or net worth. The
equation is essentially:
Assets − Liabilities = Owners’ Equity
Although this is mathematically correct, it does not reflect the un-

derlying nature of the accounting process. The left side of the Balance
Sheet, the assets, are the resources a firm has available to use. The right
side of the Balance Sheet contains the liabilities and owners’ equity, and it
is how the firm financed its resources. Both are independently measured
and if they are not equal, then a mistake has been made somewhere in
the recording process. The mere fact the Balance Sheet balances does not
guarantee that mistakes have not been made.
A simplified Balance Sheet was presented in Exhibit 2.1. An example
of a comparative Balance Sheet in a more traditional format is presented
in Exhibit 3.1.2
First, note the amounts are “as at” (or “as of ”) a specific date. In this
case, December 31, 2015 and December 31, 2016. The amounts are re-
ported for a specific instant in time. The year-end does not have to be a
calendar (December 31) year-end. A firm can choose a year-end that co-
incides with its business cycle (e.g., a retail firm might choose its year-end
2
Balance Sheets can be presented on two pages, with assets on the left page and liabili-
ties and owners’ equity on the right page or, as in Exhibit 3.1, on one page with the
assets on top and the liabilities and owners’ equity on the bottom.
Exhibit 3.1
T-shirt Company’s Balance Sheets
As of December 31 2016 2015
Assets:
Cash (currency on hand and in the bank) $ 25,000 $ 20,000
Receivables (funds owed to the firm by customers) $100,000 $ 80,000
Inventory (raw materials, in process and finished products) $140,000 $ 120,000
Other (items paid in advance, e.g., utilities) $ 5,000 $ 10,000
Total current assets (becomes cash or is used within 1 year) $270,000 $ 230,000
Property, plant, and equipment (land, buildings, and $350,000 $ 300,000
machinery)
Total assets (total resources the firm has to run its business) $620,000 $530,000
Liabilities and owners’ equity:
Accounts payable (amounts owed to the firm’s suppliers) $ 105,000 $ 72,000
Wages payable (amounts owed to the firm’s employees) $ 15,000 $ 5,500
Total current liabilities (to be paid within 1 year) $ 120,000 $ 77,500
Long-term debt (borrowed funds to be repaid after 1 year) $ 200,000 $ 200,000
Total liabilities (funds financed from non-owners) $ 320,000 $ 277,500
Contributed capital (funds provided by the owners) $ 220,000 $ 220,000
Retained earnings (profits earned and not given to the owners) $ 80,000 $ 32,500
Total owners’ equity $ 300,000 $ 252,500
Total liabilities and owners’ equity (must equal total assets) $620,000 $530,000
to be shortly after the busy holiday season), but many firms choose cal-
endar year-ends.
Second, note the example does indeed balance (Assets = Liabilities +
Owners’ Equity = $530,000 in 2015 and $620,000 in 2016).
Third, the amounts can change over time, but do not have to. In
the example, both long-term debt and contributed capital do not change
(they remain at $200,000 and $220,000, respectively). In this case, the
firm apparently did not raise additional long-term debt or funds from its
owners in 2016.
Finally, retained earnings increased from $32,500 to $80,000. This
means the firm earned and kept $47,500. The firm may have earned more
than $47,500 (e.g., $58,500) and given the extra (e.g., $11,000) to the
owners. More on this shortly.
Debit to the Left, Credit to the Right

As mentioned at the start, accounting is an information system. It is de-
signed with checks and balances. One, as noted previously, is that the Bal-
ance Sheet has to “balance” (i.e., the left side of the equation, assets, must
equal the right side of the equation, liabilities and owners’ equity). A sec-
ond part of the system is that the total debits must equal the total credits.
Total Debits = Total Credits
(or total amounts on the Left = total amounts on the Right)
What is a debit and what is a credit? To an accountant, the word debit

means “to the left” and the word credit means “to the right.” Left or right
of what?
Let us back up a bit. Each account (remember, there is an account for
everything the firm keeps track of ) has its own page in a book that ac-
countants name the “General Ledger” (now located on a hard drive some-
where in the cloud). Each page states the name of the account (e.g., Cash
in Bank X in City Y) and normally has five columns. The first column
shows the date of the transaction being recorded. The second is a reference
column used to indicate if they have checked a specific item (i.e., when
looking for a mistake). The third describes the transaction (e.g., why the
firm received the cash or paid it out). The two last columns are used to
record the amount of a transaction. A debit is entering the amount in the
fourth column (to the left of the fifth column), and a credit is entering an
amount in the fifth column (to the right of the fourth column).
Cash
Date Description Debit (left) Credit (right)
But when is an account debited or credited? Excellent question. Assets

are increased with debits and reduced with credits, whereas liabilities and
equity are increased with credits and reduced with debits. Why? There is
no logical reason; it is simply the convention.3
3
Decided by Luca Pacioli, a Venetian monk, who wrote down the modern system of
accounting over 500 years ago.
Again, to an accountant, the word debit simply means left and the
word credit simply means right. Not good or bad, not up or down, just
left and right. Let us start with an owner investing $500 in a firm by giv-
ing $500 in cash to the firm. The accounting would be treated as follows:
Cash (asset)
2/20/2015 LW deposited funds $500
Contributed capital
2/20/2015 LW deposited funds $500
Note, an asset (cash) increases and an owners’ equity account also in-
creases.4 The Balance Sheet balances. Next the funds are placed in the firm’s
bank account, and the following entries to the accounting records are made:
Cash (asset)
2/20/2015 Deposit funds in bank $500
Cash-in-bank (asset)
2/20/2015 Deposit funds in bank $500
Note, an asset (cash) decreases, and another (cash in bank) increases.

Total assets are still $500, and owners’ equity is still $500 (as it has not
changed), so the Balance Sheet is still in balance.
You may have a different perception of the term debit and credit be-
cause of how you have heard the terms used. For example, you may have
deposited funds in a bank which then “credits” your account. The bank
is not actually doing anything to your accounting records. The bank is
adjusting its own accounting records. The bank receives cash and so deb-
its its own cash account. The bank now owes you funds, so it credits
4
The detailed accounts would include a separate owners’ equity account for each
owner.
a liability with your name (and note the debits equal the credits). The
bank’s records would be treated as follows:
Cash (asset)
2/20/2015 Funds received from LW $500
Deposits (liability)
2/20/2015 Funds owed to LW $500
The system is designed to limit mistakes by requiring, for each trans-

action, an equal total amount of debits and credits recorded in the related
accounts. Mistakes can, of course, still occur if the wrong accounts are
used or if there are matching mistakes in the debits and credits.
As shown previously, if assets are increased with debits, then assets
must be reduced with credits because the total debits must equal the total
credits. For the same reason, because assets are increased with debits, li-
abilities and owners’ equity are increased with credits. Remember, the
Balance Sheet is based on the equation:
Assets = Liabilities + Owners’ Equity
The above may sound confusing, but to understand accounting, you

only have to remember three things (okay, there is some additional lan-
guage and techniques as well):
1. The Balance Sheet equation is Assets = Liabilities + Owners’ Equity.

2. Accounts on the left side of the Balance Sheet equation (assets) are
increased with a debit (which means left) and reduced with a credit
(which means right). Accounts on the right side of the Balance Sheet
equation (liabilities and owners’ equity) are increased with a credit
and reduced with a debit.
3. Total debits = Total credits.
There is no rational for why a debit increases an asset and a credit

reduces it. This is an arbitrary decision. However, once set, it then makes
mathematical sense that if assets are increased with a debit and reduced
with a credit, then liabilities and owners’ equity would be increased with
a credit and reduced with a debit. Liabilities and owners’ equity are on the
other side of the equation, so their treatment is the opposite of how assets
are treated. Remember, the idea is to catch mistakes; having total debits
equal total credits is a means to that end.
The balance of an account equals the total debits less the total credits
posted to it. If the debits exceed the credits, the account has a debit bal-
ance. If the credits exceed the debits, the account has a credit balance.
Occasionally, there is a sixth column that provides a running total of this
debit or credit balance.5
Accountants often use an abbreviated form of the account called a T
account, which looks like a T with the account name on top and then the
debits on the left side and the credits on the right side. The T account is
basically the last two columns of the formal account above.
The net debit or net credit balance is shown in a T account after draw-
ing a line under the debits and credits. For example, if total debits in a
particular account are $1.5 million and total credits are $1.2 million, the
account has debit balance of $300,000, which would be inserted in the
debit column as follows.
Cash
$1,500,000
$1,200,000
$ 300,000
An Illustration
Let us illustrate with an example. Imagine the first five transactions of a
business are as follows:
1. The owners’ give the firm $220,000 cash for their ownership inter-
est in the firm. Cash, an asset, increases by $220,000 with a debit.
Contributed capital (CC), an owners’ equity account, increases by
5
One old convention is to write debit balances with black ink and credit balances in
red ink.
$220,000 with a credit. Assets = $220,000 = owners’ equity and

total debits = total credits = $220,000.
2. The firm borrows $200,000 long-term, agreeing to pay 7 percent in-
terest once a year, at the end of the year, for 10 years and then repay
the loan. Cash gets another debit, increases by another $200,000,
and now has a $420,000 balance. Long-term debt (LTD) is cred-
ited $200,000. Cash, still the only asset, now has a $420,000 debit
balance (meaning the firm has $420,000 in its cash account). Liabil-
ities are now $200,000 credit (the long-term debt), whereas owners’
equity is $220,000 credit, for a total liabilities and owners’ equity
of $420,000 credit. (Total assets = total liabilities and owners’ eq-
uity = $420,000, and total debits = total credits = $420,000).
3. The firm buys some equipment for its operations, paying $310,000
cash. An asset account, called property, plant and equipment (PP&E),
increases by $310,000 with a debit and cash decreases by $310,000 (with
a credit). The firm now has two assets, cash of $110,000 ($420,000 −
$310,000) and PP&E of $310,000 for total assets of $420,000. Li-
abilities and owners’ equity remain unchanged at $420,000.
4. The firm orders 10,000 T-shirts for $6 each, which it plans to resell.
No debits or credits are required here because the firm has not yet re-
ceived anything (it has no resources yet to increase), has not given up
any assets (so there is nothing to reduce), and does not yet owe any
funds. Had the firm prepaid, then cash would have decreased and
an asset (perhaps called inventory receivable) would have increased
because the firm paid and is now owed something. However, because
neither the firm nor its supplier has paid or delivered, there is not yet
any debit or credit to record.
5. The raw materials (the T-shirts) arrive, but payment is not made
immediately because the supplier allows the firm 30 days to pay.
Therefore, inventory increases with a debit of $60,000 (10,000 units
at $6 each), and a liability, called accounts payable (A/P, meaning
amounts owed to suppliers of goods and services), increases with a
credit of $60,000. Total assets are now $480,000: cash of $110,000,
inventory of $60,000, and PP&E of $310,000. Total liabilities and
owners’ equity is also $480,000: A/P of $60,000, LTD of $200,000,
and CC of $220,000.
The accountant would show these transactions in her journal by list-

ing the date, the account to be debited or credited with the amount,
and an explanation. The convention is to list the accounts to be debited
first and then the accounts to be credited with the latter being indented
(creating amounts on the left and right) followed by a short explanation
as follows:
(1) January 1, 2015 Cash $220,000

Contributed capital $220,000
Owners gave the firm $220,000 in new capital to start operations.
(2) January 2, 2015 Cash $200,000

Long-term debt $200,000
Firm issues $200,000 of 10-year debt paying 7 percent once a year.
(3) January 3, 2015 PP&E $310,000

Cash $310,000
Firm purchases $310,000 of equipment paying cash.
(4) January 6, 2015 Firm orders 10,000 T-shirts for $6 each
(5) January 8, 2015 Inventory $ 60,000

Accounts payable $ 60,000
Ordered inventory arrives, payment due in 30 days.
At some point after the event (it can be soon after or much later), the
amounts are recorded or entered in the specific accounts (accountants call
doing this “posting”) as follows:
Cash
Credit
Date Description Debit (left) (right)
1/1/2015 (1) Owner investment $220,000
1/2/2015 (2) Issued debt $200,000
1/3/2015 (3) Purchased PP&E $310,000
Merchandise inventory
1/8/2015 (5) Received 10,000 $60,000
T-shirts
Property, plant and equipment

1/3/2015 (3) Bought equipment $310,000
Accounts payable
1/8/2015 (5) Received T-shirts, $60,000
unpaid
Long-term debt
1/2/2015 (2) Issued debt $200,000
Contributed capital
1/1/2015 (1) Owners’ investment $220,000
Note, the above accounts are listed in the order they would ap-
pear on the Balance Sheet. This could also be done using T accounts as
follows:
Cash Inventory PP&E A/P LTD CC

220 220
200 200
310 310
60 60
Note, the ending balance in cash is a debit of 110 (the debits 220 +
200 less the credit or 310).
We can add up all the debits (220 + 200 + 60 + 310 = 790) and
they equal the total credits (310 + 60 + 200 + 220 = 790). We can
also net the debits and credits for each account and then calculate the
total that gives us: cash 110 + inventory 60 + PP&E 310 = total as-
sets = 480, compared to: accounts payable 60 + long-term debt 200 +
contributed capital 220 = total liabilities and owners’ equity = 480.
Total debits equal total credits and the Balance Sheet balances.
Today, we can instead use a spreadsheet with plusses and minuses
instead of debits and credits.6 This leaves a greater chance of making a
mistake from an accountant’s point of view but is perhaps easier to follow.
The spreadsheet would be done as follows:
Cash Inventory PP&E A/P LTD CC

+220 +220
+200 +200
−310 +310
+60 +60
The account totals remain the same; only the format is changed. Al-
though some may prefer spreadsheets, it remains important to at least
understand debits and credits as virtually all accountants think and talk
about accounting in this way. That said, for most of the following discus-
sion, we will use a spreadsheet with plusses and minuses.
The Income Statement

Up to this point, all the transactions illustrated have involved only Bal-
ance Sheet accounts (assets, liability and equity accounts). It is now time
to consider Income Statement accounts (revenue and expense accounts).
The Income Statement links into the Balance Sheet through the re-
tained earnings account. The Income Statement is for a period of time,
normally a year, whereas the Balance Sheet is as at an instant in time.
At the end of each year, all the Income Statement accounts are reset to
zero. The profit or loss is then entered into the retained earnings (R/E)
6
Note, in a spreadsheet, all accounts are increased with a plus and decreased with a minus.
account. Thus, once a year, the retained earnings account is increased

if the firm had a profit and reduced if the firm had a loss. The retained
earnings account is also decreased when any funds are returned to the
owners, which are called dividends. This can be stated as an algebraic
formula as follows:
Opening R/E 1 Profit 2 Loss 2 Dividends 5 Ending R/E

The Balance Sheet shows the resources a firm owns and controls as
well as how the resources were financed at an instant or snapshot in time.
On the other hand, the Income Statement, which is also called a State-
ment of Profit or Loss, shows a firm’s performance and its components
over a period of time. The Income Statement contains two broad catego-
ries of accounts: revenues (the quantity of items sold or services provided
times the price per unit) and expenses (the costs to provide the items
sold or services provided). The Income Statement accounts are considered
“temporary” accounts as they represent amounts accumulated over a cer-
tain period of time (month, quarter, or normally, a year) and are periodi-
cally reset to zero. Exhibit 3.2 provides an example for our hypothetical
T-shirt firm.
Exhibit 3.2
T-shirt Company’s Income Statements
For the year ended December 31 2016 2015
Revenue (units sold times price per unit) $ 500,000 $ 400,000
Cost of goods sold (units sold times cost per unit) $ 350,000 $ 300,000
Gross profit (revenue—cost of goods sold) $ 150,000 $ 100,000
Selling, general, and administrative expenses (business $ 46,000 $ 36,000
costs)
Operating profit (profits before financing charges and taxes) $ 104,000 $ 64,000
Interest expense (financing, or borrowed funds, costs) $ 14,000 $ 14,000
Profit before tax (profits after financing but before tax) $ 90,000 $ 50,000
Income tax (the government’s take, in this case 35%) $ 31,500 $ 17,500
Net profit (also called the “bottom line”) $ 58,500 $ 32,500
For example, assume 2015 is the first year of operation for the T-shirt
firm, which started in January. This means the retained earnings account at
the start of 2015 would have been $0 (the firm had no profits or losses at its
inception). From the 2015 Income Statement, we see profits of $32,500,
and the Balance Sheet retained earnings account has a year-end balance of
the same amount. This means that the firm made no distributions to the
owners in the first year. How do we know how much the firm distributed to
owners? The previous equation has four elements: an opening balance, a
profit or loss, a potential distribution to the owners, and an ending bal-
ance. With any three, you can compute the fourth using algebra. In other
words, fill in what you know and solve for what you do not know.
Opening Balance + Income (or −Loss) − Dividends = Ending Balance
$0 + $32,500 − $? = $32,500
How much were dividends? They have to be $0 in order for the equa-
tion to balance. Therefore, no dividends were paid in 2015.
In 2016, the firm starts the year with an opening balance in retained
earnings of $32,500. How do you know that? Remember, all Balance Sheet
accounts are at a specific instant in time. The amount a firm has at mid-
night December 31, 2015, will be the same amount it has one second past
midnight the morning of January 1, 2016. Hence, the ending balance last
year is the opening balance this year. From the 2016 Income Statement,
we see profits of $58,500. This means retained earnings started the year at
$32,500 and increased by $58,500 bringing the total to $91,000. However,
the amount of retained earnings at the end of 2016 is only $80,000. How is
this possible? The firm must have paid the owners the difference of $11,000.
Opening Balance + Income (−Loss) − Dividends = Ending Balance
$32,500 + $58,500 − $? = $80,000
How much were dividends? To balance, they must have been $11,000.
This is one of the keys to accounting: the math has to work. In the
example, we compute dividends as the missing variable. In reality, the
firm would have the opening balance, the income (or loss), the dividends,
and the closing balance. If the math did not work as above ($32,500 +
$58,500 − $11,000 = $80,000), it would mean a mistake had been made
somewhere. That is how the accounting system, one of check and bal-
ances, works.
Linking the Income Statement into the Balance Sheet

The process for how accounting links the Balance Sheet and Income
Statement also reflects how accounts are treated. As noted previously,
the Balance Sheet accounts are considered “permanent” accounts as
they are cumulative over time and represent the account balance as at an
instant in time. The Income Statement accounts are considered “tem-
porary” accounts as they represent amounts accumulated over a certain
period of time (month, quarter, or normally, a year) and are periodi-
cally reset to zero. The Balance Sheet and Income Statement are linked
when the Income Statement accounts are reset to zero (called closing
the accounts).
Back up a bit. How are Income Statement accounts increased and de-
creased? With a debit or credit? Revenues are increased with a credit because
they eventually increase owners’ equity, whereas expenses are increased
with a debit as they eventually decrease owners’ equity. Again, the ap-
plication of credits and debits may seem confusing, but it will become
clearer and clearer as you come to understand the accounting process. Let
us break down the Balance Sheet Equation as follows:7
Assets = Liabilities + Owners’ Equity, where
Owners’ Equity = Contributed Capital (CC) + Retained Earnings

(R/E), where
R/E = R/Eat the start of the year + Profit (or −Loss) − Dividends, and
7
There are differences in accounting and terminology based on the type of firm (i.e.,
proprietorships, partnerships, and corporations). For simplicity, the illustrations will
use the corporate form with owners’ referred to as stockholders (or shareholders).
Profit (or Loss) = Revenue − Expenses,
where there is a profit if Revenues > Expenses (and a loss if Revenue ,

Expenses).
We can rewrite the equation as:
Assets = Liabilities + CC + R/Eopening amount + Revenue − Expenses

− Dividends.
The revenue accounts increase the right hand side of the equation. For ex-
ample, if a T-shirt is sold for $8 cash, the firm increases the cash account by $8
with a debit and the revenue account by $8 with a credit. The cash account is
on the left side of the equation, and the revenue account is on the right side of
the equation. This means revenue accounts are treated like the liabilities and
owners’ equity accounts (increased with credits and decreased with debits).
Expenses do the opposite. For example, when the T-shirt is sold, the firm has
one less T-shirt on hand. Assume the T-shirt cost $6. The firm would then
decrease its T-shirt inventory account by $6 with a credit and increase its Cost
of Goods Sold (COGS) by $6 with a debit. This means expenses are treated
like assets (increased with debits and decreased with credits).
This also explains the “as at” for Balance Sheet accounts and the “for
the period ending” for Income Statement accounts. The Balance Sheets
accounts are a running total. The Income Statement accounts are for
a specific period of time and are linked to the Balance Sheet through
retained earnings. This link occurs at the end of the accounting period
(normally a year) when the Income Statement accounts are reset to zero
(closed) with the profit or loss (the difference in the revenues and ex-
penses) entered into the retained earnings account.
At the end of the period, the Income Statement’s revenue accounts, which
would have credit balances from activities during the period, are reduced to
zero with debits. The required balancing credit is made to retained earnings,
thereby increasing the owners’ equity account on the Balance Sheet.
Next, the Income Statement’s expense accounts, which would have
debit balances, are reduced to zero with credits. The balancing debit is
made to retained earnings, thereby reducing the owners’ equity account
on the Balance Sheet.
In sum, the Balance Sheet’s retained earnings account is in-
creased when there is a profit (i.e., when revenues exceed expenses)
and decreased when there is a loss (i.e., when expenses exceed rev-
enues). For simplification, the process involves debiting each revenue
account, crediting each expense account, and then making one credit
(if a profit) or debit (if a loss) to retained earnings for the net difference
in the totals.
For example, imagine a firm begins the year with retained earnings
of $100,000. During the year, the firm has revenues of $60,000 and ex-
penses of $45,000. At the end of the year, before the revenue and expense
accounts are reset to zero, the account totals would show:
Retained earnings Revenue Expenses
$100,000 $60,0000 $45,000
Then, at year-end, the revenue and expense accounts would be reset

to zero as follows:
Retained earnings Revenue Expenses
| $100,000 | $60,000 $45,000 |
| $ 60,000 $60,000 | |
$45,000 |________ ________|________ _______ | $45,000
$115,000 $0 $0
Similarly, any dividends, which are the firm’s distributions to owners,

are treated like expenses. The dividend account is increased with debits
as the cash payment requires a reduction to the cash account, which is
done with a credit. The dividend account is reset to zero at the end of
the period with a credit, and the corresponding debit is made to retained
earnings. However, dividends do not appear on the Income Statement.
There is a third statement, the Statement of Retained Earnings, which
shows the change to this account. However, this statement can be easily
reconstructed from the Balance Sheet (which gives the opening and clos-
ing/ending amounts for retained earnings) and Income Statement (which
gives the firm’s profit or loss for the period).8 We only need simple algebra
and the amounts from these two statements to solve for the amount of
dividends. Using our previous formula:
R/EOpening + Income (−Loss) − Dividends = R/EEnding
8
Remember, the closing amount from the prior year is the opening amount this year
for all Balance Sheet accounts.
“An analogy: Most cars have two standard odometers (which shows
miles or kilometers driven): A cumulative odometer (which cannot
be reset) shows the total miles driven since the car was made. A trip
odometer (which can be reset by pushing a button) reflects the miles
driven from the last time the trip odometer was reset. For example,
assume the cumulative odometer begins the day with 7,600 miles and
the trip odometer shows 0. During the day 140 miles are driven. At the
end of the day, before the trip odometer is reset, the cumulative odom-
eter shows 7,740 miles and the trip odometer shows 140. When the
trip odometer is reset to zero the cumulative odometer is unchanged.
Now imagine an accountant had designed the odometers. Before the
trip odometer is reset, the cumulative odometer would be unchanged
at 7,600 miles and the trip odometer would show 140 miles. Then,
when the reset button is pressed, both odometers would change to
7,740 and 0. In effect, retained earnings on the Balance Sheet does not
show cumulative earnings less amounts paid to the owners until the
Income Statement accounts are reset to zero.”
Continuing the T-shirt Seller Example

Let us continue our example of the T-shirt firm, assuming the following ad-
ditional events in its first year of operations (items 1–5 are on pages 34–35):
6. The firm sells 10,000 T-shirts for $8 each, receiving full payment at
the time of sale.
7. The firm pays for the first 10,000 T-shirts and then orders and re-
ceives another 60,000 T-shirts for $6 each. By year-end, the firm has
paid for all but 12,000 of the T-shirts it purchased during the year.
8. During the rest of the year, the firm sells another 40,000 T-shirts for
$8 each, but now gives some customers 30 days to pay. At year-end,
the firm has been paid for 30,000 of these T-shirts but is still owed
for 10,000 of them.
9. Half way through the year, the firm decides it should get insurance.
The insurance firm charges $20,000 for a 1-year insurance policy. The
firm pays the full $20,000 on July 1, 2015.
10. The firm incurs various operating costs during the year, other than the
insurance. These other costs include a $10,000 reduction in the value
of PP&E (more on this later in the book), $2,000 for advertising,
and $14,000 for wages. At year-end, the firm has paid the workers
$8,500 and still owes them $5,500.
11. Interest on the debt is paid (at a rate of 7 percent per year).
12. Estimated taxes (computed at the rate of 35 percent of profit before
tax) are paid.
The entries to record each of these events are as follows:
(6a) Cash $ 80,000

Revenue $ 80,000
Sell 10,000 T-shirts for $8 each.
(6b) Cost of goods sold $ 60,000

Inventory $ 60,000
Record the reduction in inventory from selling 10,000 T-shirts.
(7a) Accounts payable $ 60,000

Cash $ 60,000
Paid balance owed for purchased T-shirts.
(7b) Inventory $360,000

Accounts payable $360,000
Record the T-shirt inventory of 60,000 units at $6 each.
(7c) Account payable $288,000

Cash $288,000
Paid for 48,000 T-shirts costing $6 each (still owe for 12,000 T-shirts).
(8a) Cash $240,000

Accounts receivable $ 80,000
Revenue $320,000
Sold 40,000 T-shirts for $8 each, collected all but
10,000 × $8 = $80,000.
Note, this type of entry, with more than a single debit and credit, is called a
compound entry.
(8b) Cost of goods sold $240,000

Inventory $240,000
Record the reduction in inventory from selling 40,000 T-shirts
(costing $6 each).
(9a) Prepaid insurance (PPI) $20,000
Cash $20,000
Paid for 1 year’s insurance expense on July 1, 2015.
Note, prepaid insurance is an asset because it is a resource that the firm

owns or controls and will provide future economic benefits based on a
past transaction or event. It is a deferred cost that will be reduced over
time against revenue. A discussion of revenue and expense recognition is
provided in the next chapter.
(9b) Insurance expense $10,000

Prepaid insurance $ 10,000
Record the use of half of 1 year’s insurance.
(10) Selling, general, and administrative $26,000

Cash $ 10,500
PP&E $ 10,000
Wages payable $ 5,500
Incur expenses, pay cash, reduce PP&E, and owe wages.
Note, the $10,000 credit to PP&E is a reduction to the asset to reflect the
part of its cost which is allocated to the current year’s revenue. A detailed
explanation for how this is done is provided in Chapter 6.
(11) Interest expense $14,000

Cash $ 14,000
Record the cost of borrowing $200,000 at 7 percent.
(12) Tax expense $17,500

Cash $ 17,500
35 percent tax on profit before tax of $50,000.
The T-shirt Company’s Balance Sheet as at the end of year 2015

Cash $ 20,000 Accounts and wages payable $ 77,500
Accounts receivable $ 80,000 Long-term debt $200,000
Inventory $120,000 Total liabilities $277,500
Prepaid insurance $ 10,000 Contributed capital $220,000
Total current assets $230,000 Retained earnings $ 32,500
Property, plant and $300,000 Owners’ equity $252,500
equipment (net)
Total assets $530,000 Total equities $530,000
A spreadsheet would have the Balance Sheet entries that are mentioned
in next page (all amounts are in $ thousands).
46
A/P and
Item Cash A/R Inventory PPI PP&E W/P LTD CC R/E
1. 220 220
2. 200 200
3. (310) 310
5. 60 60
6a. 80
6b. (60)
7a. (60) (60)
7b. 360 360
7c. (288) (288)
8a. 240 80
8b. (240)
9a. (20) 20
9b. (10)
10. (10.5) (10) 5.5
11. (14)
12. (17.5)
Close 32.5
Totals 20 80 120 10 300 77.5 200 220 32.5
A spreadsheet would have the following income statement items:

Item +Revenue −COGS −SG&A −Interest −Tax
1.
2.
3.
5.
6a. 80
6b. (60)
7a.
7b.
7c.
8a. 320
8b. (240)
9a.
9b. (10)
10. (26)
11. (14)
12. (17.5)
Close (400) 300 36 14 17.5
Totals 0 0 0 0 0

47
The T-shirt Company’s Income Statement for the year ended 2015
Revenue $400,000
Cost of goods sold $300,000
Gross profit $100,000
Selling, general, and administrative $ 36,000
Earnings before interest and tax $ 64,000
Interest expense $ 14,000
Profit before tax $ 50,000
Income tax $ 17,500
Net profit $ 32,500
The Bottom Line

Debit means to the left. Credit means to the right. The Balance Sheet
equation is: Assets = Liabilities + Owners’ Equity. Balance Sheet ac-
counts are permanent accounts showing the item’s value as at a point in
time. Income Statement accounts are temporary accounts meaning they
are reset to zero at the end of each period at which time retained earnings
is increased (if there is a profit) or decreased (if there is a loss). These are
the basics of the accounting cycle.
The next chapter presents the accrual method of accounting, which is
what most organizations use, where revenue is recognized when goods or
services are provided and expenses are matched to revenues.
CHAPTER 4
Accrual Accounting
The first three chapters introduced the reader to the accounting cycle,
the Balance Sheet, and the Income Statement as well as established that
accounting provides a picture of an organization but within limits and
that there is no truth in accounting. The Balance Sheet provides a start-
ing point to understand a firm’s resources and how it financed them at a
point in time. The Income Statement is meant to show not only whether
a firm made money (or not) but also how it generated the profit (or loss).
The Income Statement is also used as the first step in forecasting a firm’s
future cash flows.
This chapter illustrates the accrual method of accounting, which is
what most organizations use, where revenue is recognized when goods
or services are provided and expenses are matched to revenues. In other
words, regardless of when cash is actually received, under the accrual
method of accounting, revenue is recognized at the time of delivery. If
cash is received before the goods are provided or services rendered, the
cash account increases (since the firm has the cash), and a liability account
is also increased (the liability reflects that the firm owes the customers
goods or services). When the goods or services are then provided, the
revenue is recognized and the liability is reduced. If cash is paid at the
time of delivery, then cash increases and the revenue is recognized. If cash
is going to be paid after delivery, then at the time of delivery, the revenue
is recognized and a receivable account increases (a receivable means the
customer owes the firm money). This is not as straightforward as it may
seem, as there are some important complications.
When Should Revenue be Recognized?

Let us begin with revenue, the quantity of goods or services sold times the
price per unit. This seems simple, and often it is. In the T-shirt vendor
example in Chapter 2, $20 cash was received when the T-shirt was sold.
There was no issue over the timing of the revenue because it was cash on
delivery, or cash at the time of transfer. However, payments for goods or
services are often received some time after delivery and, occasionally, be-
fore delivery. In Chapter 3, some T-shirts were sold with payment coming
after delivery. In this case, revenue was still recognized when the goods
were delivered and an asset account reflecting the amount customers
owed for the T-shirts was set up.
Under the “Cash Basis” of accounting, revenue is recognized only when
cash is received. This concept will be discussed in more detail in Chapter 11.
For now, we will put it aside. Until Chapter 11, we are going to use what is
called the “Accrual Basis” of accounting. That is, revenue will be recognized
when it is earned!1 In other words, although it can occur with a cash pay-
ment, the receipt of cash does not dictate revenue recognition.
So, when is revenue recognized? New rules (both U.S. GAAP and IFRS)
set up five steps:2
1. Identify a (legally enforceable) contract between the vendor and

customer.
2. Identify the performance obligations (what has been promised).
3. Determine the transaction price (including any price concessions,
rebates, and so on).
4. Allocate the transaction price to the performance obligations.
5. Recognize the revenue as each performance obligation is satisfied.
1
There used to be an investment bank called E.F. Hutton (the firm with the same
name today is a new firm which bought the name), which had a great advertise-
ment where the announcer said, “We make our money the old-fashioned way: We
earn it!” The firm had another great advertisement where it said, “When E.F. Hutton
talks, people listen.” This may have nothing to do with accounting, but interesting
nonetheless.
2
Prior rules had many of these elements. The new rules are set to be implemented in
the U.S. as of December 15, 2017 for public companies.
Accrual Accounting 51
Revenue is recognized when the product has been delivered or a por-

tion of the service provided and when cash has been collected or the firm
is reasonably assured cash will be collected.3 When revenue recognition
precedes cash collection, an asset (e.g., accounts receivable) is set up.
When cash collection precedes revenue recognition, a liability (e.g., de-
ferred revenue) is set up.
There are numerous additional details beyond the scope of this book,
so let us just take a look at a few examples:
How does a hairdresser recognize revenue? Like our simplified T-shirt
firm earlier, services are provided (the hair is cut) and cash is paid imme-
diately. Revenue is recognized when the hair is cut because that is when
the revenue is earned.
How does an orange grove recognize revenue? The question here is one of
timing: In what period should revenue be recorded? Assume there are three
parts to derive revenue from an orange grove: growing the fruit, harvest-
ing the fruit, and selling the fruit. Further assume these happen in three
distinct periods: Period 1, Period 2, and Period 3, respectively. How much
revenue, if any, can the firm recognize in Period 1? None. Period 2? None.
Why? Because to recognize revenue you need to know the quantity and
price, which the firm will not know until the oranges are sold. Because
firms do not have to use a calendar year-end, it would make sense for an
orange grove to pick its year-end after the selling season. What if the firm
had two orange groves, one in Florida and one in Australia and the seasons
did not overlap? A choice would have to be made. For one of the groves,
the revenue from growing (and possibly harvesting) oranges will only be
recognized in the following year. What if someone pays a flat fee for all the
oranges grown in the Florida and Australia groves? Could you then recognize
part of the revenue from growing? Maybe. This possibility will be discussed
a bit more below.
How would a vineyard recognize revenue? Imagine a case of wine is sold
for $1,200 with an additional $100 5-year storage fee. Because these are
two separate transactions, the $1,200 is recognized at the time of sale
and the $100 over the 5 years. But, what if the price is $1,250 for the wine
3
Interestingly, reasonable assurance of collection is set at 50 percent under IFRS and
75 to 80 percent in the U.S.
and 5-year storage? In this case, each separate product or service must be
valued. This can be done in many different ways. One could value the
wine at $1,200 and the storage at the remaining $50. ($1,250 − $1,200).
Another could prorate the wine as $1,250 × $1,200 / ($1,200 + $100)
and the storage at $1,250 × $100 / ($1,200 + $100). The firm’s choice
would be disclosed in the Notes to the Financial Statements.
How would a real estate developer recognize revenue? Once again, it
depends. If the developer is building homes and then selling them, rev-
enue cannot be recognized until they are sold because the price will only
be known when they are sold. However, if the developer is building the
home for a particular customer under a contract, then revenue can be
recognized as the home is being built. Here, an assumption (with justi-
fication) has to be made as to what percentage of the work is done each
period.
How should a firm that builds nuclear submarines for the government
under contract recognize revenues? Can it recognize revenue as they build the
submarine? Only if it has built submarines before and are reasonably sure
the submarine will float (submarines do have to float).4 If this is the first
submarine it has ever built, then perhaps it should wait until the subma-
rine is built and proven to work.
Finally, how would a travel agency recognize revenue? For this ex-
ample, let us go back to a travel agency in the pre-Internet era. A
bricks-and-mortar travel agency where travelers would come in or call
in, and an agent would book an airline flight. The agency would collect
money from the traveler and give it to the airline. After the flight, the air-
line would pay a commission of, for instance, 5 percent to the agency. Let
us assume, there are two flights booked this year for travel next year. One
is for $1,000 from Boston to New York in business class. This is a full fare
ticket, fully refundable or changeable. The other is for $300 from Boston
to New York in coach class. This is a nonrefundable, non-changeable,
use-it-or-lose-it ticket. The commission on the first ticket is $50. The
commission on the second ticket is $15. Can any revenue be recognized this
year or does the travel agency have to wait until next year, after the flights have
4
Submarine engineers, those who design submarines, are often in the submarine on its
maiden voyage. An example of proper incentives (design the submarine well or die).
taken place? When is revenue earned? At the time the work is done, when the
ticket is booked, or when the flight is taken? For the first ticket, the client
may cancel the flight and then no commission will be paid. The second
ticket is locked in and the commission will be paid whether the customer
flies or not. Regardless, all the revenue would be recognized in the year
the tickets are booked as this is when the work was done. However, an
allowance would be made for an estimate of the percentage of refundable
tickets being canceled. This estimate would be based on past experience
and industry trends.
Thus, the travel agency recognizes revenue when the ticket is sold and
might set up some allowance for canceled flights. But how much revenue
should be recognized? Is the revenue $1,300 (with a related inventory cost of
$1,235 for a gross profit of $65) or is revenue the $65 commission? In the
pre-Internet era, revenue was $65, but in the post-Internet era, it was
sometimes $1,300, at least when Internet travel agencies were first set up.
Brick and mortar Internet

Revenue $65 $1,300
Cost of goods sold n/a $1,235
Gross profit n/a $ 65
What difference does it make? As can be seen from above, it has no

effect on profit because the Internet travel agencies start with the ticket
price and then deducts the amount the airlines keep. We end up at the
same place. So, why did some Internet travel agencies do it this way? The
Internet agencies were trying to raise capital and hoped investors would
focus on the top line, revenue, and be fooled into thinking the agen-
cies were generating more business and growing faster than comparable
bricks-and-mortar agencies.
At the time of the brick-and-mortar travel agencies, a rule of thumb
(i.e., rough estimate) for the value of a travel agency was five times rev-
enue. In other words, if you were buying a travel agency you would pay
about five times revenue, with variations to take into account location
and other factors. An Internet travel agency was worth more than this be-
cause a brick-and-mortar agency could only sell to local people, whereas
the Internet agency could, at least in theory, sell to anyone in the country,
or even the world. Imagine that the Internet travel agency, because of its
greater growth potential, was worth 10 times revenue. The estimate of the
agency’s worth should have been 10 times the commission of $65. How-
ever, if an investor blindly used revenue without understanding what it
entails, he might make the estimate taking 10 times $1,300. When many
of these Internet travel agencies went bust, investors sued and said they
had been duped, misled by the accounting. However, it was obvious what
the agencies were doing. Investors were only misled if they accepted the
first line as revenue without thinking about what it really meant, without
looking at the numbers, and/or without having a basic idea of account-
ing. Although there is no doubt many of the Internet firms were trying
to mislead investors, the investors appear to have been quite ready to be
misled.5 Today the travel agent would be viewed as an “agent” and would
be required to show only the commissions as its revenue.
Expense Recognition
How about costs? When are the costs recognized? Accountants talk about
expenses, which they define as outflows from the firm, using up of assets,
or incurring liabilities in the process of producing revenue or carrying out
the firm’s daily operations during a period.
The concept of recording expenses in the same period as the revenues
to which they relate is a fundamental principal in accounting (and re-
ferred to as the matching principal). Expenses are not defined as cash
disbursements and can be recorded with, before, or after cash payments.
When expense recognition precedes cash collection, a liability (e.g., ac-
counts payable) is set up. When cash payment precedes expense recogni-
tion, an asset (e.g., prepaid expenses) is set up.
Expenses are recognized in one of two ways. First, there are those
expenses that can be tied or “matched” to revenues. For example, think
of the T-shirts being sold. We have a problem of how to cost the T-shirt
5
Understand that when the Internet was established and travel agencies started doing
online bookings, they said it was a new industry, a new economy, and that old ac-
counting practices did not matter. They claimed they purchased the ticket from the
airlines and sold it 2 seconds later (in fact they first obtained the order and funds, then
bought the ticket and delivered it—somehow it seems to be economically the same as
the brick-and-mortar process).
that is sold, but the idea that when one T-shirt is sold, the cost of the
shirt is matched (expensed) to the revenue makes sense. T-shirts are not
expenses as the firm buys (or pays) for them from its suppliers; that is,
when T-shirts become part of the firm’s resources (cash down, inventory
up). The T-shirts are expenses when they are sold.
Similarly, the hair dresser could match the cost of hair spray and gel
to cutting hair. The real estate developer could match the cost of materials
and workers, adding them to the cost of the land, and putting it in the
same period as the revenue. The travel agency could match the cost of the
phones and workers to selling the tickets.
Second, those expenses that cannot be tied to revenues are recorded in
the period incurred. For example, advertising is expensed in the year the ad-
vertisement runs (not when paid). Why not match the advertising to the rev-
enue it helps produce? Because there is simply no reliable way to do it. In fact,
it is impossible to even know whether an advertisement will be successful in
the sense of providing any future benefits. There are many, even entertain-
ing and award winning, advertisements that failed to increase sales.6
Note that there are two ways for management to alter accounting
numbers. One is through the choice of which accounting technique, es-
timates or assumptions to use. The other is to change the underlying eco-
nomics (in other words, decide to postpone or move up certain activities).
If the firm is having a bad year and wants to increase profits, it can do so
by delaying when its advertisements run. If the advertisement is delayed
until next year, the cost is delayed until next year. Of course, this could
adversely affect next year’s sales—but that is another issue. Likewise, in
a good year, the firm could increase advertisements, thereby reducing
profits in the current year with the benefit from the advertisements in
the following year. Remember, there is no truth in accounting; you must
6
One example from the late 1980s was an award winning series of advertisements
for Isuzu automobiles. In the advertisements a salesman, called Joe Isuzu played by
the comedian David Leisure, lied about the cars. The advertisements supposedly did
increase traffic at the car dealers (and so arguably a success according to the advertis-
ing agency) but failed to increase the firm’s revenues and the cars are no longer sold in
the U.S. See https://www.youtube.com/watch?v=J5IgatESU9A (viewed January 19,
2015 at 9.30 p.m. EST).
understand the process in order to use accounting to gain insight into the
underlying economic reality.
Standard Presentation of the Income Statement

There are many different ways to present an Income Statement. One
common standard was shown in Chapter 3 and is represented below:
The T-shirt Company’s Income Statement

for the Year Ended December 31
Revenue (units sold times price per unit)
Cost of goods sold (units sold times cost per unit)
Gross profit (revenue less cost of goods sold)
Selling, general, and administrative expenses (business costs)

Operating profit (profits before financing charges and taxes)
Interest expense (cost of financing or borrowing funds)

Profit before tax (profits after financing but before taxes)
Income tax (the government’s take, in this case 35%)

Net profit (also called the “bottom line”)
Not all firms have a cost of goods sold (COGS). Some service firms
create a cost of services provided, but many do not, choosing instead
to simply list the various individual cost categories. All the items pre-
sented are broad categories, representing the minimum required level of
disclosure. More detailed information is always allowed: The question is
whether the firm wants to provide it. Remember, there is a cost to provide
additional information, both in its preparation and also in how it could
be used by others (competitors, governments, reporters, and so on).
Many additional details, if not included in the Income Statement it-
self (as for the Balance Sheet), will be provided in the Notes to the Finan-
cial Statements. Let us consider revenue in more detail.
A single line for revenue would mean this amount is “net” of any re-
turns and discounts. It may include a reduction for possible non-payments
(discussed more in the next chapter). Also, depending on the nature of the
firm, owners and others may want to know more about the details of the
revenue. Firms are required to provide information about major classes of
Exhibit 4.1
Apple Inc. selected sales details
Net sales by operating
segment ($ millions) 2015 2014 2013
Americas 93,864 80,095 77,093
Europe 50,337 44,285 40,980
Greater China 58,715 31,853 27,016
Japan 15,706 15,314 13,782
Rest of Asia Pacific 15,093 11,248 12,039
Total 233,715 182,795 170,910
Net sales by product
($ millions) 2015 2014 2013
iPhone 155,041 101,991 91,279
iPad 23,227 30,283 31,980
Mac 25,471 24,079 21,483
Services 19,909 18,063 16,051
Other products 10,067 8,379 10,117
Total 233,715 182,795 170,910
Unit sales by product
($ Thousands) 2015 2014 2013
iPhone 231,218 169,219 150,257
iPad 54,856 67,977 71,033
Mac 20,587 18,906 16,341
products as well as by geographic locations. For example, although Apple

Inc.’s Income Statement reports net sales of $233,715 million for its year
ending September 26, 2015, the report also discloses additional informa-
tion as presented in Exhibit 4.1.
Notice that the bulk of Apple’s sales come from the Americas and from
the iPhone but the highest growth is in China. The iPhone is still growing
both in amount and units and at a higher rate than in the prior year. iPad
sales are declining and Mac sales are somewhat flat. It is clear this data al-
lows a reader to understand more about what Apple does and where and
how it is changing over time. There is a wealth of data in an annual report
beyond what is revealed in the financial statements themselves.
Revenue is not the only item for which additional information is pro-
vided. Every category of expenses also has more information, and often
there are breakdowns of profit by product category and region (in ef-
fect mini-income statements). How much did Apple spend on research and
development? Apple spent $8.1 billion on R&D in 2015, up from $6.0
billion in 2014 and $4.5 billion in 2013. This information is provided
directly in the Income Statements. How much did Apple spend on advertis-
ing? Apple’s advertising expense was $1.8 billion in 2015, up from $1.2
billion in 2014 and $1.1 billion in 2013. This detail is found in the ad-
ditional information in the Notes to the Financial Statements.
It is also worth noting how the expenses are categorized and the vari-
ous subtotals presented on the Income Statement. First, there is a differ-
ence between the selling price and the direct cost (e.g., in Apple’s case, the
cost to produce the product sold) and it is called gross profit. It reflects
how much more a firm can sell its products for over the cost to produce
or procure them. Then, the costs to operate the firm over the period are
presented in a broad category called selling, general, and administrative
(SG&A) expenses. This gives a subtotal called operating profit comprised
of gross profit minus SG&A. It provides the profitability of the firm be-
fore financing charges and corporate income taxes. Financing charges
come next with the subtotal of profit before taxes. The expense items
end with taxes and then net income or net profit (the two terms are used
interchangeably and are also referred to as the “bottom line”).7
The Bottom Line

The Income Statement tries to measure a firm’s performance when
revenues are earned and match expenses to the same period of revenues
when possible and otherwise when incurred.
The next chapter begins our walk down the Balance Sheet looking at
accounting terminology and techniques.
7
A firm is considered in the “black” if it has made a profit or in the “red” if it has a loss.
Note, the Thanksgiving Shopping Day known as Black Friday comes from the idea
that it takes until sometime in late November for a retailer to make enough to cover its
operating expenses for the year (and move from being in the red to being in the black).
CHAPTER 5
Current Assets
Chapters 5 through 10 can be thought of as a walk down the Balance

Sheet. They will delve into the terms and techniques presented on the
Balance Sheet and Income Statement.
Assets, as noted in Chapter 3, are resources that a firm owns or controls.
Current assets are those the firm will turn into cash or use within 1 year
(i.e., get paid by customers, sell inventory, expire prepaid insurance, and
so on). Let us start with the first-listed asset on the Balance Sheet: cash.1
Cash
Apple, Alphabet (Google), Microsoft, and Exxon are the four largest U.S.
(and world) public firms and have lots of cash.2 According to their Balance
Sheets, the firms’ cash hoards (including cash, cash equivalents, and market-
able securities that they could rapidly turn into cash) are as follows:
Apple Google Microsoft Exxon
(Billions) 12/26/15 12/31/15 12/31/15 12/31/15
Cash and cash equivalents $21.1 $16.5 $7.2 $3.7
Marketable securities (short- and
184.5 56.5 107.0 0.0
long-term)
Total $205.6 $73.0 $114.2 $3.7
1
The ordering of assets differs by country. Firms in the US and Canada normally list
cash first.
2
They were the largest U.S. firms by market capitalization (the market price of a share
times the number of shares held by the public) as of January 29, 2016. Apple is
#1 (at $542.7 billion), Alphabet (Google) is #2 (at $523.6 billion), Microsoft is #3
(at $440.1 billion), and Exxon (ExxonMobil) is #4 (at $324.1 billion).
Of all the accounting numbers, cash is the one closest to its true,
underlying economic value. But how could cash represent anything but
its true underlying economic value? Actually, even cash can have slight
differences based on how it is estimated. If all the cash is in one cur-
rency (e.g., U.S. dollars), then there is no estimation required and there
should be only one number for cash. However, if a firm holds different
currencies (as all the firms above do), then the question is how to value
the foreign currency. Normally this is done using the year-end exchange
rate, but there may be more than 1 year-end exchange rate. There is the
bid (the price or rate someone is willing to pay for the currency), the
ask (the price or rate at which someone is willing to sell the currency),
and the close (the price or rate of the actual final trade). Which exchange
(market) should be used? (There are different currency exchanges.) Should
the bank commission be included? What about currencies that do not have
large active markets? Even for cash, which at first seems to be an easy
valuation situation, there may be some assumptions and estimates re-
quired. However, differences in the final number should not be very
large. Also, there are no alternative accounting choices like those we
saw in Chapter 2 for inventory (i.e., first-in first-out [FIFO] and last-in
first-out [LIFO]). Cash is a number that is normally as trustworthy as
an accounting number can be.
Cash seems pretty straightforward: It is actual currency that the firm
holds in one or several bank accounts, and at worst you will have to con-
vert cash held in foreign currencies into the currency in which you are
reporting your financial statements.
But what is a cash equivalent? It is a marketable security that the firm
could almost instantly convert to cash and something that is expected to
become cash in a very short period of time. One common example is a
U.S. government debt, money market accounts, and commercial paper
that matures within a few months of a firm’s year-end. However, dif-
ferent firms have slightly different definitions for what they include as
cash equivalents (again, the Notes to the Financial Statements must be
read). Most firms only include items that automatically become cash (i.e.,
bonds3), excluding even highly traded equities.
3
Bonds are discussed in detail in Chapter 9.
Current Assets 61
Today, there is an active foreign exchange market between the U.S.

dollar and the Russian ruble. However, this was not always the case.
Prior to the fall of the Berlin Wall on November 9, 1989, the Russian
ruble was not an actively traded, highly liquid currency. Indeed, there
was a very large difference between the “official” exchange rate and the
rate that could be obtained in private deals.
Pepsico started shipping Pepsi concentrate to the Soviet Union in
1974. The problem for Pepsi was how to repatriate the Russian rubles
it received as payment. Pepsi solved its problem by swapping its soft
drink concentrate for vodka (Stolichnaya). The vodka was brought to
the U.S. and sold. Currency problem solved!
See http://articles.latimes.com/1990-04-10/news/mn-1040_1_soviet-
union (viewed on 24 November 2014 10 p.m. EST)
For example, Apple’s definition of cash equivalents is:

“All highly liquid investments with maturities of three months or less at
the date of purchase are classified as cash equivalents.”4
Google has a similar definition:
“We classify all highly liquid investments with stated maturities of three
months or less from date of purchase as cash equivalents and all highly
liquid investments with stated maturities of greater than three months as
marketable securities.”5
Note that both firms indicate the securities must mature, which
means they are bonds, and the maturity must be 3 months from the date
of purchase, which means it is at most 3 months after year-end.6
Marketable Securities
If there is an active market where securities (i.e., debt or equity) are actively
traded, the securities are considered “marketable.” Shares of Apple Inc. are
4
See Apple Inc. | 2015 Form 10-K | 47.
5
See Google Inc. | 2014 Form 10-K | 52.
6
As an aside, one item that should not be included as a cash equivalent would be post-
age stamps. Just for fun, try returning them to the post office and asking for a refund.
They are not easily turned into cash.
clearly marketable securities, as would be the debt of the U.S. government

(U.S. government debt is the most highly traded of all securities). Inter-
estingly, a firm’s intention often matters in deciding whether an account
is considered current or long-term. For example, when Microsoft invested
$150 million in Apple Inc. back in August 1997, the investment was meant
to last more than a year.7 So despite the fact that Microsoft could have sold
the Apple shares for cash at any time, the investment was listed as long-
term. Intentions matter, and intentions can change. Any time Microsoft
decides that it might sell the Apple shares within the next year, the firm can
reclassify them as a current asset. If a firm invests in marketable debt securi-
ties and the securities will mature in less than a year, then they must be clas-
sified as short-term. However, if the debt securities will not mature for more
than a year, then the classification is based on management’s intentions.
How are marketable securities valued? At their cost or market price? This is
actually a complicated issue. The short answer is, as so often in accounting, “it
depends.” Equity securities that are held as short-term assets must be valued
“mark-to-market.” This means they must be valued at their market price on
the Balance Sheet date. For debt securities held as short-term assets, manage-
ment has the choice of mark-to-market valuation or using the cost plus ac-
crued interest (accrued interest is the amount of interest earned from the date
the bonds were purchased to the Balance Sheet date if no interest is paid in
between, or from the last interest payment to the Balance Sheet date if inter-
est is paid after the bonds are purchased but before the Balance Sheet date).
As will be discussed later, firms are sometimes required to reduce an
asset’s value when it falls below cost. However, other than for short-term
marketable securities, it is rare for firms to increase an asset’s value above
cost. Why is the historical cost of an item a core part of valuing assets in ac-
counting? Because the price of an exchange between two unrelated parties
(in other words, how much it cost to purchase the asset) is considered a
much more reliable and verifiable number than management’s (or their
paid proxy’s) estimate of market value. Marketable securities are an excep-
tion because there is a reliable and verifiable outside value.8
7
See: http://news.cnet.com/2100-1001-202143.html (viewed 11/24/14 10 PM EST).
8
However, the mark-to-market rule remains highly controversial. A more complete
discussion is provided in Accounting for Fun and Profit: Understanding Advanced
Topics in Accounting.
Current Assets 63
Accounts Receivable
Firms often allow customers a set period of time from when goods or ser-
vices are delivered until payment by the customer must be made. Com-
mon terms would be n/30 (net 30) or n/60 (net 60), which means the
payment is expected within 30 or 60 days, respectively. However, some-
times vendors add an incentive to induce their customers to pay earlier.
Terms such as 2/10 n/60 means the customer can take 2 percent off the
purchase price if payment is received by day 10, otherwise full payment is
expected by day 60.9 Most utilities and credit cards give consumers n/30
after that there is an interest charged for late payment.
Any amounts owed to a firm by an individual or by another firm can
be called a receivable. The bulk of these are owed by customers, and these
are called accounts receivables (A/R). We will focus exclusively on A/R,
but note that other types of receivables exist.
A firm recognizes (records) revenue when it delivers goods or provides
services, as discussed in Chapter 4.10 If payment is not made at the same
time, an A/R is set up. When the financial statements are prepared, the
remaining total unpaid receivables are listed on the Balance Sheet. Addi-
tionally, an accounting estimate is required to reflect the fact that not all
receivables will be ultimately paid. Sometimes, customers will simply not
have the ability to pay (e.g., firms enter financial distress and bankruptcy
and either pay nothing or perhaps pay some small amount, often the
9
Note, 2/10 n/60 translates to roughly an annual rate of 14 percent. With 2/10 n/60 a
customer who properly manages its cash should pay either on Day 10 or Day 60. This
means a 2 percent discount is offered for paying 50 days earlier. Because there are roughly
seven 50-day periods in a year (365 / 50), this means a firm taking the discount will earn
approximately 14 percent over the year (7 × 2%). If the customer’s cost of capital is less
than 14 percent, she should take the discount, otherwise it is better to pay on Day 60.
10
Another interesting aside is the terms of delivery. Goods are considered delivered
when they are placed on the transport if the terms are free on board (FOB) but not
until they reach the customers place of business if the terms are free to destination
(FTD). Now consider a firm loading its product onto a ship, the terms are FOB, and
the merchandise falls into the water between the dock and the ship. Are the goods
considered to have been delivered? It depends on where the crane loading the goods is
located. If the crane is on the dock, then the goods are not considered delivered to the
ship until they are on the ship. However, if the crane is on the ship, then the goods are
considered delivered as soon as the goods are lifted off the dock.
proverbial 10 cents on the dollar, years later). Sometimes, a percentage of

customers (hopefully not many) engage in theft and try to vanish without
paying.
It may be 6 months to a year before a firm realizes a specific customer
will not pay. In order to match the cost of uncollected sales (called bad
debts expense) into the same period as revenues (the sales of the goods
and services), an estimate of what will ultimately not be collected is made.
How do accountants make a year-end estimate of what will be ultimately
not be collected (called allowance for doubtful accounts [ADA])? There are sev-
eral different ways. One is to examine each customer and estimate whether
the payment will be made. This is very time consuming and is done only for
very large or key customers. The more common methods are to use either a
percentage of credit sales (total sales are used if the breakdown between cash
sales and credit sales is not known) or through a process known as aging of
accounts receivable. Both methods of estimating the ADA (i.e., the Balance
Sheet amount) and bad debt expense (i.e., the Income Statement amount)
include historical firm and industry experience along with expectations of
how the overall economy will do (if the economy is heading into a reces-
sion, the estimated collections may be reduced, whereas when the economy
is coming out of a recession, the estimated collections may be increased).
These two methods, Percentage of Sales and Aging of Accounts Re-
ceivable, also illustrate how the choice of accounting method creates a
trade-off between the Balance Sheet and the Income Statement. That is,
the choice of the accounting method determines whether the firm’s Bal-
ance Sheet better reflects (is closer to) economic reality or whether the
firm’s Income Statement provides better guidance in predicting future
cash flows. The percentage-of-sales method is an Income Statement ap-
proach in the sense that it does a better job of matching costs to revenues.
The aging method is a Balance Sheet approach in that it provides a better
estimate of the amount that will actually be collected.
In other words, the more accounting focuses upon Balance Sheet
valuations the greater the potential distortion in the Income Statement.
Conversely, the more accounting focuses upon income measurement the
greater the potential distortion in the Balance Sheet. This is not just true
for bad debts, it is true for numerous measurement issues as will be shown
in later chapters.
Current Assets 65
Percentage of Sales
Let us start with the Percentage of Sales (% Sales) method. How does this
method work? At year-end, management estimates the percentage of sales
that it expects it will be unable to collect (using the firm’s historical expe-
rience combined with industry and economic trends).
As an example, assume a firm has annual sales of $1 million and that,
to keep the example simple, all the sales were on credit. It is the firm’s first
year of operations, so the firm does not have any uncollected amounts
that carried over from the prior year (i.e., the opening balance of A/R is
$0). Of the $1 million in sales on credit this year, the firm has collected
$850,000 by year-end. The firm’s customers therefore together owe the
remainder of $150,000 ($1 million − $850,000 = $150,000). In other
words, the firm has an Accounts Receivable balance of $150,000 (Re-
member, the amount on the Balance Sheet for A/R is a total of numerous
customers). The formula to compute A/R is:
Opening A/R + Sales − Collections = Ending A/R

$0 + $1,000,000 − $850,000 = $150,000
If the firm estimates that 2 percent of sales will never be collected, this
translates to an estimate of $20,000 (2 percent of $1 million). The firm
would show “net” A/R of $130,000 (the $150,000 less the $20,000 that
it expects not to collect). The firm would also reduce profits by $20,000
(matching the cost of the uncollected amounts, or bad debts, to the rev-
enues), thereby reducing the year-end Retained Earnings account.
Note that the firm is setting up an estimated amount for the total
amount it expects not to collect. It does not adjust the actual individual
customer accounts until it knows which specific customer(s) will not pay,
which means it does not change A/R itself. Why not? It is because the
amount on the Balance Sheet for A/R is the total of numerous customer
accounts that owe money to the firm. The firm does not yet know which
customer’s account to reduce. Thus, a new account is created called ADA
(allowance for doubtful accounts) that reflects the estimate of what will not
be collected. This is a contra or negative asset account (it is increased with
a credit and reduced with a debit) in that it is attached to an asset account
(e.g., A/R) and reduces it (as opposed to reducing the individual accounts
that make up A/R). Thus, there are many individual customer accounts to-
taling $150,000 (with a debit balance) and there is the new ADA showing
a year-end balance of $20,000 (with a credit balance). The Balance Sheet
can show both but usually just shows the net of $130,000.
Balance Sheet: Accounts receivable $150,000
Less ADA $ 20,000
Net accounts receivable $130,000
Income Statement: Bad debt expense $ 20,000
Remember: The ADA is a Balance Sheet number reflecting the

amount a firm expects not to collect. The bad debt expense is an Income
Statement number reflecting the amount of non-payments matched to
this year’s revenues.
In the first year, there is no trade-off between the Balance Sheet valu-
ation of receivables and the income measurement because bad debt ex-
pense and the ADA are the same. This will change once estimates do not
match actuals in future years.
Assume that in its second year of operations, the firm actually collects
$135,000 of the first year’s year-end A/R. This means the firm made a
mistake in its first year financial statements by overestimating the ADA
and the bad debts expense. The first year’s Income Statement was $5,000
lower than it would have been had management estimated correctly (at
$15,000 instead of $20,000). Reported total assets and retained earnings
were also $5,000 lower than they would have been. However, the Balance
Sheet and Income Statement of the first year are not corrected for this
type of mistake. At the time the statements were prepared, the numbers
were based on the best estimate available. The only time prior year’s state-
ments are changed is when there was a major numerical mistake, a case
of fraud, or when the government mandates a change in an accounting
choice with a retroactive change in prior year’s numbers. The fact that
an estimate later proves to be wrong does not by itself lead to changes in
prior year’s financial statements.
Now assume that the same firm has sales of $1.3 million in the sec-
ond year, of which it collects $1.1 million. Remember, we said above
that in the second year, the firm also collects $135,000 of the A/R from
the first year. How much is the firm owed at year-end? The answer should
be $200,000 ($1.3 million less $1.1 million), but until adjustments are
Current Assets 67
made the A/R balance will be $215,000. This is because the math of the
A/R accounts, prior to an adjustment to the ADA, is as follows:
Opening A/R + Sales − Collections = Ending A/R

$150,000 + $1,300,000 − $1,235,000 = $215,000
The amount owed at the start of the second year is same as the first
year’s ending balance which is the total A/R of $150,000. Sales during the
year were $1.3 million. The firm collected $1,235,000 ($135,000 of the
amount owed from the prior year plus $1.1 million of this year’s sales).
At some point (the firm can do it at any time of its choosing), the firm
will recognize the $15,000 that it will definitely not collect and “write off”
the specific customer accounts (remember, the A/R at the end of the first
year was $150,000 and in the second year only $135,000 of that was col-
lected, leaving an actual uncollected amount of $15,000). The write-off
is done by reducing the appropriate individual customer accounts and by
reducing the ADA. For example, imagine Clown Costume Inc. (CCI),
which owed $15,000 filed for bankruptcy and is expected to be unable
to make any payments. The account of CCI is reduced (credited) by
$15,000 (with a note it is for lack of payment) and the ADA account is
reduced (debited) by $15,000.
Year 2 ADA $15,000

Clown Costume Inc. receivable $15,000
100 percent write-off of amount owed because of CCI bankruptcy
Thus, we restate the A/R equation as follows:
Opening A/R + Sales − Collections − Write-offs = Ending A/R
$150,000 + $1,300,000 − $1,235,000 − $15,000 = $200,000
Accounts receivable reflects the amount owed after adjusting for those
specific customers which the firm has recognized will not pay.
An aside: In the individual customer accounts, the firm will keep
track of the write-off. The account will be tagged to indicate that it has
been reduced to zero not because the customer paid but because it was
written off as uncollectible. If the customer ever returns and wants to
purchase merchandise, the firm may refuse because of the prior nonpay-
ment or may ask the customer to first repay what had been owned plus a
“finance fee.”
The ADA, as noted previously, is a contra or negative account on the
Balance Sheet. It reduces the net A/R shown on the Balance Sheet. The
formula for the ADA is as follows:
Opening ADA + Bad Debts Expense − Write-offs = Ending ADA
Note, the write-off lowers both the A/R and the ADA, so it has no
effect on the net A/R.
For example, prior to the write-off (and an adjustment for this year’s
bad debt expense), the A/R was $215,000 and the ADA was $20,000 for
a net of $195,000.
Opening A/R+ Sales − Collections − Write-offs = Ending A/R

$150,000 + $1,300,000 −$1,235,000 − $0 = $215,000

$20,000 +0 − $0 = $20,000
After the $15,000 write-off (and still before an adjustment for this
year’s bad debt expense), the A/R is $200,000 and the ADA is $5,000 for
a net of $195,000.

$150,000 + $1,300,000 −$1,235,000 − $15,000 = $200,000
$20,000 +0 − $15,000 = $5,000

Current Assets 69
Under the Percentage of Sales method, the Income Statement amount

for bad debts expense is estimated as a set percentage of credit sales. In
the first year, the bad debt expense and the ADA are the same (assuming
no write-offs in the first year). In future years, the bad debt expense and
year-end ADA are unlikely to be the same because prior year’s mistakes
remain in the ADA.
Remember, the ADA is a Balance Sheet account and, like all Bal-
ance Sheet numbers, it is cumulative, showing the value as at an instant
in time. However, because of how it is computed it accumulates mis-
takes over time. The Percentage of Sales method estimates each year’s
bad debt expense. To the extent the estimate is wrong, the Income
Statement and ADA are wrong. However, unlike the Income Statement
number, the ADA is not reset to zero each year. Under the Percentage
of Sales method (again, where bad debts expense is being calculated),
the ADA is increased by bad debts expense and reduced by write-offs,
which means past year’s errors will cumulate over time when using this
method.
Assume that at the end of year 2, the firm still estimates that 2 per-
cent of sales will not be collected; this would mean that the estimate for
year 2’s bad debts expense is $26,000 (2% × $1.3 million). The equation
for ADA for years 1 and 2 is as follows:
Opening ADA + Estimated Bad Debts − Write-offs = Ending ADA

Expense
Year 1: $0 + $20,000 − $0 = $20,000
Year 2: $20,000 + $26,000 − $15,000 = $31,000
The estimate for bad debts expense does not affect A/R, which re-
mains at $200,000:
Opening A/R + Sales − Collections − Write-offs =Ending A/R

$150,000 + $1,300,000− $1,235,000 − $15,000 = $200,000
This means that the year 2 ending net A/R on the Balance Sheet is
$169,000 (ending A/R for year 2 of $200,000 minus the ending ADA for
year 2 of $31,000).
As can be seen previously, the ending ADA is $31,000 (or $5,000
more than the current year’s bad debt expense of $26,000). The $5,000
mistake from the overestimation of bad debt expense in year 1 is left on
the Balance Sheet, which increases the ADA from $26,000 to $31,000
and reduces the net A/R from $174,000 to $169,000.
Why not adjust the Balance Sheet to take into account the prior year’s
overestimation? It is because, as noted, the Percentage of Sales method is
an Income Statement approach. This means that this method is trying to
match revenues and costs (bad debt expense is a cost). The best estimate
of this year’s bad debts is $26,000. This is the best number to match
against this year’s revenue.
In order to adjust the Balance Sheet’s net A/R to the more accurate
value of $169,000 requires a $5,000 adjustment to both the Balance
Sheet ADA account and the Income Statement bad debts expense. This
means, in order to remove the prior year’s overestimation of $5,000
requires this year’s bad debt expense to be lowered from $26,000 to
$21,000. However, using an amount of $21,000 for year 2’s bad debt
expense does not fulfill the Percentage of Sales method’s goal of match-
ing costs (which is $26,000 in year 2) to that year’s revenues.
The firm made a mistake last year when it estimated bad debts to be
$20,000 and ultimately only $15,000 were not collected. The firm has
two choices: (1) leave the mistake on the Balance Sheet and properly
match this year’s revenues and costs with a bad debt expense of $26,000
or (2) adjust the prior year’s error on this year’s Income Statement by
reducing bad debt expense to $21,000 and thereby removing the $5,000
mistake from the Balance Sheet, which would then show the year-end
ADA as $26,000 instead of $31,000. The Percentage of Sales method
chooses option (1) and leaves the error on the Balance Sheet. Again, the
Percentage of Sales method is an Income Statement approach and focuses
on matching a year’s cost to that same year’s revenues.
Using the Percentage of Sales method, the mistakes usually average
out over time because of overestimating one year and underestimating the
next. It is possible for a firm to continually over- or underestimate, but at
Current Assets 71
some point if the ADA account becomes too large it must be reduced by
using a lower amount of bad debt expense – in that year the firm will not
match costs to revenues as well.11
Aged Accounts Receivable

By contrast, the Aged Accounts Receivable (Aged A/R) method is a Bal-
ance Sheet approach that tries to reflect the true economic value of the
Balance Sheet item. This means that at the end of each year, the ADA on
the Balance Sheet is adjusted so the net A/R is set at what is expected to
be collected. Doing so means that bad debts on the Income Statement is
adjusted for prior errors and will not match as well as under the Percent-
age of Sales method.
The Aged A/R method computes the ending ADA. This is done by
first listing each individual uncollected sale at year-end by age (i.e., by
how much time has passed since the sale). As an example, let us again
assume that the firm ended its first year with A/R of $150,000. Let us
further assume they are aged as follows:
Sale was made Amount

0–30 days $ 80,000
31–60 days $ 50,000
61–90 days $ 15,000
91–180 days $ 4,000
Over 180 days $ 1,000
Total $150,000
The firm estimates an uncollectible rate for each time period (cat-
egory). Note that if the firm has given customers 30 days to pay, then the
$80,000 sold within the last 30 days is not yet late. The more time has
passed since the sale was made without payment, the less likely it is that
the firm will ultimately be able to collect payment and the higher the
default probability. For example:
11
The ADA can never be more than the total A/R because it cannot reduce A/R
below $0 (A/R − ADA > $0). Also, the ADA can never go below $0, it cannot in-
crease net A/R.
Probability of Estimated
Sale was made Amount default (%) ADA
0–30 days $ 80,000 4.0 $ 3,200
31–60 days $ 50,000 12.0 $ 6,000
61–90 days $ 15,000 30.0 $ 4,500
91–180 days $ 4,000 50.0 $ 2,000
Over 180 days $ 1,000 80.0 $ 800
Totals $150,000 $16,500
There are several items to note at this point. First, the estimates
under the two methods (% Sales and Aged A/R) are not likely to pro-
duce the same ending net A/R amounts. Second, aging is generally
thought to be a more accurate estimate of what will ultimately be col-
lected because it is more specific and takes into account what has been
collected to date (while, as noted previously, % Sales does a better job
of matching). Finally, and most importantly, the amount being esti-
mated under the Aged A/R method is NOT bad debt expense. Rather,
the amount being estimated is the ending ADA amount (remember,
the amount being estimated under the % Sales method is the bad debt
expense). This means we compute ending ADA and solve for bad debts
expense:
Opening ADA+ Bad Debt Expense− Write-offs = Ending ADA
Ending ADA − Opening ADA + Write-offs = Bad Debt Expense
Continuing our previous example, in the first year the ADA and bad
debt expense are the same amount ($16,500) because in the first year
there are no opening ADA balances and no write-offs.
Our first year-end A/R is unchanged as follows:

$0 + $1,000,000 − $850,000 − $0 = $150,000
Current Assets 73

$0 + $16,500 − $0 = $16,500
Thus, the ending net A/R value is $133,500 because the bad debt
expense and ADA are now $16,500 (instead of the $20,000 under the %
Sales method) because of the different estimation.
For simplicity, we estimate the second year-end ADA with the same
percentages for each category as in year 1:
Probability of default Estimated

Sale was made Amount (%) ADA
0–30 days $100,000 4.0 $ 4,000
31–60 days $ 60,000 12.0 $ 7,200
61–90 days $ 25,000 30.0 $ 7,500
91–180 days $ 10,000 50.0 $ 5,000
Over 180 days $ 5,000 80.0 $ 4,000
Totals $200,000 $27,700
This means that at the end of the second year, the net A/R on the Bal-
ance Sheet is $172,300 (the ending A/R of $200,000 minus the estimated
ADA of $27,700) and the bad debt expense on the Income Statement is
$26,200.
Opening A/R + Sales − Collections − Write-offs = Ending A/R

$150,000 + $1,300,000 − $1,235,000− $15,000 = $200,000

$16,500 + $26,200 − $15,000 = $27,700
The bad debts expense was estimated by solving the equation as

follows:
Ending ADA − Opening ADA + Write-offs = Bad debt expense

$27,700 − $16,500 + $15,000 = $ 26,200
As noted previously, the different methods result in different esti-

mates. In the % Sales method above, the first year estimate was $20,000,
whereas in the Aged A/R method, it was $16,500. The actual amount
turned out to be $15,000. This means the first method overestimated bad
debts expense by $5,000, whereas the second overestimated bad debts
expense by $1,500.
Additionally, the % Sales method leaves prior year’s error in the ADA.
By contrast, the Aged A/R method moves the error to the bad debts ex-
pense. This can be seen here as the ADA is calculated as $27,700 but the
bad debt expense is $26,200. The $1,500 difference is the prior year’s error
(using the Aged A/R method). Essentially, since the ADA reflects the year-
end estimate of what will be collected, the prior year’s error is included in
bad debts expense (in this example lowering it by $1,500). Thus, the Aged
A/R method produces a Balance Sheet closer to economic reality in terms
of what the firm expects to collect. However, the Aged A/R method does
not match costs to revenues as well as the % Sales method does.
Although there are no set guidelines, a U.S. Department of Com-
merce study provides the following:12
Receivable age Estimated loss (%)

0–30 days 4
31–60 days 10
61–90 days 17
91–120 days 26
Over 120 days Extremely difficult to collect
Inventory
In a retail operation like our T-shirt vendor example in Chapter 2, items
are purchased and resold. Purchases of inventory are listed under current
12
See http://blog.freedmaxick.com/summing-it-up/bid/130347/Allowances-for-Doubt-
ful-Accounts (viewed November 25, 2014 2 p.m. EST).
Current Assets 75
assets until they are sold (inventory increases and cash decreases if the firm
pays immediately, or inventory increases and accounts payable increases
if the firm purchases the inventory on credit). When the items are sold,
inventory is reduced and an Income Statement account, which matches
the cost of the T-shirts to revenue, called cost of goods sold (COGS) or
cost of sales is created. The equation for the account is below, followed by
Walmart’s numbers for the year ending January 31, 2016.
Opening
Inventory + Purchases − Cost of Sales = Ending Inventory
$45.1 billion + $361.4 billion − $360.0 billion = $44.5 billion
Note that the opening and closing inventory numbers come from the
Balance Sheet, whereas the cost of sales number comes from the Income
Statement. Purchases is not provided in the financial statements and must
be computed as follows:
Purchases = Ending Inventory + Cost of Sales − Opening Inventory
Walmart includes in cost of sales not only what it paid for the mer-
chandise it has sold but also the costs of its distribution and warehouse
facilities. Likewise, the ending inventory is not only what Walmart has in
its stores but also what it has in its warehouses.
In a manufacturing operation, the accounting process is more com-
plex. First, there are three broad categories of inventory (and within each
there may be thousands of individual accounts, one for each item at each
location):
Raw materials (the unchanged inventory that goes into the final
products),
Work-in-process (partially made products), and
Finished goods (the final products ready to be sold).
The complexity occurs when computing work-in-process. As a prod-

uct is being made, raw materials are transferred both literally and in the
accounts: The raw materials move out of the raw materials account (with a
credit) and into work-in-process (with a debit). However, work-in-process
is also increased for all the costs of manufacturing. These costs include
direct labor, which is the costs of wages and related benefits of all the em-
ployees who work directly on the product. The costs also include the cost
of operating the plant (e.g., rent, electricity, and maintenance) referred to
as overhead. The equation can be written as follows:
Work-in-Processstart + Raw Materials + Direct Labor + Overhead

− Cost of Goods Manufactured = Work-in-Processend
There are a variety of ways to allocate overhead costs to specific prod-

ucts, but often it is done simply as a percentage of direct labor. For ex-
ample, if the total cost of operating a plant is $1.5 million and the total
direct labor in the plant is $1 million, then the relationship of overhead to
direct labor is 1.5 ($1.5 million / $1 million). The direct labor is traced to
individual products (i.e., with time cards) and the overhead is applied at
a rate of $1.50 per $1.00 of direct labor. Imagine the firm has only three
products, A, B, and C. Each product is charged for the actual raw materi-
als and direct labor used. Assume A uses $200,000 of raw materials and
$600,000 of direct labor, B uses $400,000 of raw materials and $350,000
of direct labor, and C uses $25,000 of raw materials and $50,000 of direct
labor. The $1.5 million of overhead is applied based on the direct labor,
and the product costs would be as follows:
Product A Product B Product C Totals

Raw materials (actual $ 200,000 $ 400,000 $ 25,000 $ 625,000
used)
Direct labor (actual $ 600,000 $ 350,000 $ 50,000 $1,000,000
used)
Overhead applied $ 900,000 $ 525,000 $ 75,000 $1,500,000
(1.5 × direct labor)
Product cost $1,700,000 $1,275,000 $150,000 $3,125,000
As the product is completed it moves out of work-in-process (with a

credit) and into finished goods inventory (with a debit). Then, when it is
sold, the process is the same as for a retailer: Finished goods inventory is
reduced (with a credit) and COGS is increased (with a debit).
To determine the amount to reduce (credit) the inventory account,
the firm must apply a cost or price to the product. Whether the product
is manufactured or is purchased in the form it will be sold, prices can vary
over time. This takes us to the question of how to cost the inventory as
Current Assets 77
it is sold, a topic already introduced back in Chapter 2. There are four

methods generally used. They are as follows:
• Specific identification,
• FIFO,
• Average, and
• LIFO
Specific identification is normally restricted to high-value items where

the customer selects a specific product. Remember, there will be an inven-
tory category for each type of product (each model, variety, size, fabric, and
so on). Clearly a customer will not care which of three identical T-shirts
she gets. By contrast, someone purchasing a car is likely to not only want a
specific model but also care about color and optional features. Thus, a local
car dealer might use specific identification to cost inventory. However, the
automobile manufacturer, which sells anywhere from tens of thousands to
millions of a particular model, would not use specific identification. Like-
wise, a single retail jewelry store might use specific identification on some
of its very expensive jewelry (e.g., diamond rings selling for over $10,000).
The benefit of specific identification is that it matches the cost exactly to
the revenue. The disadvantage is that when items are not differentiated, as
in the case of the identical T-shirts, management could manipulate prof-
its by choosing which specific (though identical) item is sold, essentially
picking the cost that the firm will report. Also, this method may be more
expensive to implement as it requires that the firm track exactly which
item sold.
FIFO, Average, and LIFO are the three most common methods used.
Average is just that, somewhere in the middle. Let us delve into FIFO and
LIFO again.
FIFO is a Balance Sheet approach. It reduces the value of inventory
on the Balance Sheet, and increases the Income Statement expense (called
COGS) when items are sold in the same order as they were purchased.
As the name implies, first-in first-out. This also means FIFO values end-
ing inventory using the cost of the last items purchased, which is a value
closer to replacement cost. Remember our T-shirt example with three
items purchased for $10, $12, and $14. If FIFO is used, when one item is
sold its cost is $10 which is the cost of the first inventory item purchased,
whereas the remaining T-shirts (i.e., the ending inventory) are together
valued at $26 ($12 + $14). The $26 is less than the likely replacement
value of $28 (2 × $14), which is what the firm would have to pay to
replace the two remaining T-shirts if the cost was the same as the $14 it
paid for the last one. However, the FIFO value is closer to replacement
cost than the LIFO value as explained below.
LIFO is an Income Statement approach. LIFO costs (reduces inven-
tory value and increases COGS) in the reverse order of that purchased.
As the name implies, last-in first-out. This makes the Income Statement
expense more representative of the likely future costs and thereby pro-
vides a better estimate of future cash flows (assuming the firm maintains
a constant or increasing quantity of inventory). In our T-shirt example,
using LIFO, when one item is sold its cost is $14 which is that of the last
inventory item purchased. The remaining T-Shirts are together valued at
$22 ($10 + $12).
The FIFO ending inventory value on the Balance Sheet is closer to
replacement value because it includes more current prices. However, the
Income Statement using FIFO is not as good an estimate of future profits
because it includes older purchase prices. The LIFO ending inventory
value on the Balance Sheet is not as close to replacement value because it
uses older purchase prices. However, the Income Statement profit gives
a better estimate of future profits because it uses more current costs.
The trade-off between the two methods, FIFO and LIFO, is the same
trade-off as between the Aged A/R method (like FIFO, a Balance Sheet
approach) and the % Sales method (like LIFO, an Income Statement
approach).
LIFO has one very important caveat: It provides management the
possibility to manipulate reported profits by undertaking the economic
action of reducing the firm’s physical quantity of year-end inventory.
Consider again the T-shirt vendor in Chapter 2. Assume the firm starts
the year with three units of inventory that cost $10, $12, and $14 for
a total of $36. Regardless of whether the firm purchases any additional
units, FIFO will always cost the sale of the first unit of inventory at $10
regardless of when it occurs. However, for LIFO, the cost is $14 if the
firm purchases no new inventory during the year. If the firm buys another
Current Assets 79
unit for $15, then under LIFO the cost of the unit sold is $15 because
LIFO stipulates that the cost of the unit sold is always the cost of the last
unit purchased. Now imagine the firm bought no new inventory during
the year. It would cost one unit at $14 (rather than $15, which appears to
be the new market price), as shown in the example below. In subsequent
years, if no new inventory was purchased, it would cost the next unit at
$12 (rather than some amount above $15 if prices keep rising).
As shown below, failing to replace units sold makes no difference for
FIFO but can affect LIFO:
FIFO layers Constant or increasing Decreasing

example Inventory units Inventory units
Opening inventory Unit 1 $10 Unit 1 $10
Purchases Unit 4 $15 None
Sell one unit and Unit 1 = $10 Unit 1 = $10
cost with FIFO
Revenue $20 $20
Cost $10 $10
Profit $10 $10
LIFO layers Constant or increasing Decreasing
example Inventory units Inventory units
Purchases Unit 4 $15 None
Sell one unit and
cost with LIFO Unit 4 = $15 Unit 3 = $14
Revenue $20 $20
Cost $15 $14
Profit $5 $6
A firm using LIFO which increases its profits by selling inventory and
not buying replacements and thereby reducing the quantity of year-end
inventory (in this case from three to two units) is said to be “eating into the
LIFO layers.” (Note, we normally assume prices are rising, but this is not
always true. If prices are falling, LIFO produces a higher profit than FIFO.)
The above also assume inventory costing is done once a year, which
used to be true before the advent of computers. Today, many firms use
what is known as perpetual costing, which means the costing is done each
time a unit is sold. This makes the timing of purchases and sales impor-
tant. Consider the following scenarios:
• Purchase a T-shirt for $10,
• Purchase a T-shirt for $12,
• Sell a T-shirt for $20, and
• Purchase a T-shirt for $14
If inventory costing is done periodically (e.g., once a year), then the

LIFO cost of the one unit sold is $14 because that was the cost of the last
unit purchased in the year. However, if the costing is done perpetually, the
LIFO cost is $12, (and the ending inventory is $24 ($10 + $14), because
when the T-shirt was sold the cost of the latest purchased item was $12.
One last inventory point before a couple of interesting stories. Inven-
tory is valued at the lower of cost or market. Cost is determined as above,
using FIFO, Average, or LIFO. Market is the selling price (minus certain
direct selling costs, like commissions). If the market is less than cost, then
the inventory has to be written down to market, and this becomes the
new cost (by convention it is not written back up if the market value
increases in the future).
The LIFO vs. FIFO Controversy

What method would you, as manager of a firm with rising inventory prices,
want to use for your public financial statements, FIFO or LIFO? Probably
FIFO. Why? Because if prices are rising, FIFO will show higher profits
than LIFO. What method would you prefer to use on your Income Tax re-
turns? LIFO. Why? Because if prices are rising, LIFO will show a lower
profit than FIFO and allow you to delay taxes.
Back to our T-shirt vendor. Imagine you purchase the three units up
front for $10, $12, and $14. Then you sell one T-shirt a year for $20, $24,
and $30. To show the highest possible profit during the first year, the firm
Current Assets 81
chooses FIFO and then is “locked in” to this accounting choice because
changing accounting choices requires an explanation and a transition year
with two sets of financial statement numbers. The firm’s profits before taxes
over the 3 years are $10 in the first year ($20 − $10), $12 in the second
year ($24 − $12), and $16 in the third year ($30 − $14). If taxes are based
on these FIFO-induced profits and the tax rate is 30 percent, the firm will
owe the government annual taxes of $3, $3.60, and $4.80, respectively.
By contrast, using LIFO will show profits before tax of $6 in the first
year ($20 − $14), $12 in the second year ($24 − $12), and $20 in the third
year ($30 − $10), with taxes equaling $1.8, $3.6, and $6, respectively. No-
tice that when we sum total profits before or after tax over the 3 years, FIFO
and LIFO result in the same 3-year sums ($38 and $26.60, respectively).
This also happens when we calculate total tax over the 3 years ($11.4).
If the firm will end up paying the same aggregate amount in taxes in the
long-term, why would it want to pay lower taxes now? Paying the govern-
ment later is generally preferred, as you can invest the funds you do not
give the government or borrow less. Essentially, by using LIFO for tax
purposes, you are able to delay a $1.2 payment from Year 1 to Year 3. The
amounts become interesting once they are in the millions, let alone the
$36.8 billion Exxon has currently delayed paying.13 (Chapter 8 provides
a detailed discussion on the time value of money.)
FIFO LIFO
Year Year 3 Year 2 Year 1 Total Year 3 Year 2 Year 1 Total
Revenue $30.00 $24.00 $20.00 $74.00 $30.00 $24.00 $20.00 $74.00
Cost $14.00 $12.00 $10.00 $36.00 $10.00 $12.00 $14.00 $36.00
Profit before
tax $16.00 $12.00 $10.00 $38.00 $20.00 $12.00 $ 6.00 $38.00
Tax (at 30 %) $ 4.80 $ 3.60 $ 3.00 $11.40 $ 6.00 $ 3.60 $ 1.80 $11.40
Net profit $11.20 $ 8.40 $ 7.00 $26.60 $14.00 $ 8.40 $ 4.20 $26.60
This means that firms with rising inventory costs would likely pre-
fer to use FIFO for the public (as it shows higher profits) and LIFO
for the government (as it delays paying taxes). Unfortunately, back in
13
According to its annual report, Exxon had deferred tax liabilities of $36.8 billion as
at December 31, 2015. See, ExxonMobil Inc. | 2015 Form 10-K | page 65. Tax pay-
ments will be discussed in more detail in Chapter 7.
1971, LIFO was not allowed in the U.S. for tax purposes and, since
prices were rising, most firms used FIFO in their public reports in order
to report higher profits to the public. After a considerable amount of
lobbying in 1972, Congress decided to allow firms to use LIFO for
tax purposes. However, Congress inserted an important caveat, firms
could only use LIFO for tax purposes if they also used LIFO in their
public reports.14
The above means a firm would save money by switching from FIFO
to LIFO by deferring tax payments but would have to report lower cur-
rent accounting profits to the public in order to do so. This is an impor-
tant point: Economically the firm would have higher cash flows this year
by deferring some of its tax payments, but to do so, it would have to lower
current reported accounting profits. Remember, as shown in the example
above, over the long-term it makes no difference.
Would you, as a manager, make the switch? Do you believe the market
will understand what you are doing or punish you for lowering profits? In
1973, eight firms listed on the Compustat database switched from FIFO
to LIFO. Their stock price rose, as apparently the market understood and
appreciated what they did. The next year 183 firms switched from FIFO
to LIFO.15
At one point, because of this tax effect, a majority of U.S. firms used
LIFO. Today the number is much less (one study of 5,000 public firms
puts the number at around 8.7 percent).16 There is also a downside risk
to using LIFO in periods of rising prices – liquidating inventory can in-
crease profits but may result in unexpected tax liabilities. Finally, a new
14
This remains true today and is, to this author’s knowledge, the only case in the U.S.
where a firm tax accounting choice is linked to the firm’s public reporting choice (i.e.,
LIFO conformity, IRS Code 472-2(e)).
15
See Gary C. Biddle and Frederick W. Lindahl, “Stock Price Reactions to LIFO
Adoptions: The Association Between Excess Returns and LIFO Tax Savings,” Journal
of Accounting Research Vol. 20, No. 2, Autumn 1982.
16
See, Kleinbard, Edward D., George A. Plesko, and Corey M. Goodman, “Is it Time
to Liquidate LIFO,” Tax Notes, Vol. 113, No. 3, pp. 237–253, October 16, 2006, and
ww2.cfo.com/accounting-tax/2006/07/the-battle-to-preserve-lifo/
Current Assets 83
problem with LIFO has arisen. Under IFRS, which are used by the Euro-
pean Union and others, LIFO is not allowed.17
What will the U.S. regulators do in response to IFRS? We shall see. (Your
author is betting on the U.S. continuing to allow LIFO for tax purposes
even if U.S. financial reporting standards are changed to align with IFRS
by prohibiting LIFO or Congress repealing the LIFO conformity rule.)
An Accountant in Dallas (Based on the 1978

TV Show Dallas)
A young man named John Ross sets off to seek his fortune. He finds it
in the oil industry and becomes very wealthy. Along the way, he not only
cheats his business partner but also steals his partner’s girlfriend, who he
marries and with whom he has three sons. The eldest of his sons, named
JR (after himself ), is pure evil. The youngest, named Robert, is a great guy
who is constantly being abused by JR. The middle son is ignored.
When John Ross dies, there was one especially interesting element in
his will: John Ross had decided he wanted whichever son was better at
managing the business to run his empire (no first-born rights to the king-
dom for JR). JR and Robert would each get one division of his business.
Then, whichever son earned more in the next 6 months would become
chief executive officer (CEO) and control the empire. Of course, measur-
ing who earned more is based on, you guessed it, ACCOUNTING!
JR was given the retail division, comprised of a chain of gas stations
selling fuel. Robert was given the exploration division, which searches for
new oil. JR would generate profits from the ongoing business of selling
oil at retail for more than it cost. Robert had to find oil and then sell it
wholesale in 6 months. Let me provide numerical assumptions (some-
thing the TV show never discussed).
17
The European Union required all public firms to adopt IFRS for their consolidated
accounts by 2005. IFRS are those issued by the International Accounting Standards
Board (IASB) an independent body based in Europe. Prior to 2001, when the IASB
changed its nomenclature to IFRS, these standards were called International Account-
ing Standards (IAS).
Assume Robert is given $30 million to explore for oil and that it costs
$10 million per well that is dug, meaning he can dig up to three wells. If
he finds oil, he gets $14.5 million per well. If there is no oil, he loses all
$10 million. The most Robert can earn if he punches three holes in the
ground and finds oil in all three is $13.5 million (three times the differ-
ence of $14.5 million and $10 million).18 To ensure he wins the contest,
JR would have to earn more than $13.5 million.
JR has 2.7 million barrels of oil on hand that his dad had purchased
for $14 a barrel (or a total of $37.8 million). The current price of oil in
1978 is $19.50 per barrel and the current selling price is $20 per barrel.
In the normal course of business, JR expects to sell 2 million barrels in the
next 6 months. Now consider the following: If JR sells 2 million barrels at
$20 per barrel, his revenue is $40 million. If he uses FIFO, his accounting
cost is $28 million and his accounting profit is $12 million. This would
be reported profit under LIFO as well if he buys no new oil. Note that his
actual economic profit is really only $1 million (the $20 selling price less
the $19.50 replacement cost times the 2 million units). However, by using
FIFO or not replacing the inventory, JR also gets the difference between
the replacement cost of $19.50 and the $14.00 his dad paid. This occurs
because the accounting records have the inventory valued at the $14 price
his dad paid. This difference is an unrealized and unrecorded holding gain
(of $5.50 per barrel in this case). It is also sometimes referred to as a hidden
reserve.
JR will win by showing a $12 million profit unless Robert drills three
wells and finds oil in all three – a very unlikely event. However, JR is not
willing to risk Robert winning, no matter how unlikely. How can JR en-
sure he earns more than $13.5 million for a guaranteed win?
JR realizes that he has to sell more than 2 million barrels of oil to
ensure a win. To do so, JR lowers his selling price from $20 to $19.05 per
barrel and sells all 2.7 million barrels instead of the 2 million he would
have sold at a price of $20.00. Now, JR is in fact losing $0.45 per barrel
on an economic basis (the replacement cost of $19.50 is $0.45 higher
18
This is a simplified example because in reality, different wells would have different
costs and the total amount they could be sold for would depend on the quantity of oil
found and its extraction costs.
Current Assets 85
than his $19.05 selling price). However, on an accounting basis, JR makes

$5.05 per barrel (the selling price of $19.05 less the accounting cost of
$14.00) for a total accounting profit of $13,635,000, coming from rev-
enue of $51,435,000 (2.7 million barrels at $19.05 per barrel) minus the
$37.8 million cost his dad paid (2.7 million barrels at $14.00 per barrel).
In fact, on an economic basis, the family loses $2,215,000: They lose
the opportunity to make $1 million in economic profit that JR would have
made selling 2 million barrels at $20, and they also lose $1,215,000 from
selling the 2.7 million barrels at $0.45 below replacement cost. However, if
we assume that JR inherits 20 percent (with others in the family getting the
balance), this means it cost him only $443,000 ($2.215 million × 20%) to
win control of the empire and the job of CEO. It cost the rest of the family
the remaining 80 percent, or $1.772 million. I did say JR was evil.
One last note: The season ended with JR getting shot. And it was
a media event with T-shirts asking: “Who Shot JR?” Was it his wife? His
Brother? One of his many mistresses? The son of his father’s former partner?
Although this is an interesting question, it is not relevant for this discus-
sion. (You have to look it up, but I will give you a hint: It was the usual
first suspect in a murder.)
Other Current Assets

These are all other resources that will be used within a year. Normally,
the items here are individually small and do not merit their own line on
the Balance Sheet and so are grouped together. This category includes
items such as prepayments for insurance, utilities, rent, wages, taxes, and
interest on debt. It can also include advances paid to suppliers or the cash
surrender value of life insurance policies (many firms have life insurance
policies on key employees).
The Bottom Line

In 2015, the J.M. Smucker Company experienced a 1.4 percent increase
in sales (from $5.61 billion to $5.69 billion).19 However, despite this in-
19
The J.M. Smucker Company owns brands, such as Smucker’s, Folgers, JIF, Pillsbury,
and Crisco, among many others. See J.M. Smucker Inc. | 2015 Annual Report |.
crease in sales, the firm profits fell by 39.0 percent (from $565.2 million
to $344.9 million). Management claims one reason for the profit decline
was the integration and debt costs of an acquisition (i.e., Big Heart Pet
Brands for $5.9 billion).
The J.M. Smucker Company

($ millions) April 30, 2015 April 30, 2014 % Change
Cash 125.6 153.5 (18.2)
Accounts receivable 430.1 309.4 39.0
Inventory 1,163.6 931.0 25.0
Other 333.0 145.2 129.3
Current assets 2,052.3 1,539.1 33.3
As can be seen from the previous table, current assets rose 33.3 per-
cent, much more than the 1.4 percent increase in sales. The firm had
an 18.2 percent drop in cash, which makes sense given the acquisition
and additional debt incurred. Cash and other current assets combined
remained about the same total dollar value as accounts receivable. Inven-
tory is the largest item, roughly three times the size of accounts receivable.
Both accounts receivable and inventory increased significantly. Why did
accounts receivable increase so much more than sales (39.0 percent versus 1.4
percent)? Probably due to the acquisition. Likewise, the increase in inven-
tory may be due to the firm stocking up on key raw materials, building
up inventory for an expected increase in sales, or primarily as a result of
the acquisition. These are the types of considerations a user of the annual
report might have. The key point is that the reader should now be able
to follow this type of discussion and understand these components of the
Balance Sheet.
The next chapter will examine noncurrent assets including property,
plant, and equipment; patents; trademarks; and other noncurrent assets.
CHAPTER 6
Long-Term Assets
Long-term assets are generally divided into three broad groups: long-term
marketable securities; property, plant, and equipment (PP&E); and other
assets. The accounting choices for long-term marketable securities are
either the same as the choices for short-term marketable securities and
merely have a different classification, or are much more complex.1 Long-
term marketable securities will be discussed in Accounting for Fun and
Profit: Understanding Advanced Topics in Accounting. This chapter will
focus on PP&E and intangible assets.
As can be seen from the information below, in its 2015 fiscal year,
Apple Inc. generated $233.7 billion in revenue and $53.4 billion in profit
with total assets of $290.5 billion. The total assets were split between
$89.4 billion of current assets and $201.1billion of long-term assets.
The long-term assets included $164.1 billion of long-term marketable
securities (remember that these are classified as long-term because Apple
does not intend to sell them within a year); $22.5 billion of PP&E;
and $13.5 billion of other assets. Chapter 12 will delve into the numer-
ous ways that exist to relate accounting numbers to each other, but for
now, we can note that Apple generated $10.39 in revenue and $2.37 in
profit for each dollar of year-end PP&E. By contrast, in its 2015 cal-
endar year, ExxonMobil Corporation generated $1.07 in revenue and
$0.06 in profit per dollar of PP&E. Apple (a computer/cell phone firm)
required much less in PP&E than Exxon (an energy supplier) to generate
each dollar of revenue.
1
As noted in the last chapter, the classification as long-term is based both on intent
(that the firm does not intend to sell the securities within the next year) as well as the
assets useful life.
Selected financial Apple Inc. ExxonMobil Corp.

information2 (billions, 2015) (billions, 2015)
Revenue $233.7 $268.9
Net income $ 53.4 $ 16.2
Current assets $ 89.4 $ 42.6
Long-term marketable securities $164.1 $ 34.3
PP&E $ 22.5 $251.6
Other long-term assets $ 14.5 $ 8.3
Total long-term assets $201.1 $294.2
Total assets $290.5 $336.8
Revenue/total assets 80.4% 79.8%
Revenue/PP&E 1,038.7% 106.9%
Net income/total assets 18.4% 4.8%
Net income/PP&E 237.3% 6.4%
PP&E2
As with any asset, when a firm acquires PP&E (i.e., gains the physical cus-
tody or title to it) an asset is increased and either cash is reduced or a liability
(accounts payable or debt) is increased (or there is a combination of the
two if a partial payment is made). The cost of PP&E includes all legal fees,
transportation, and even the costs of setting the equipment up for its first
use, if such a cost is significant. If a firm builds the PP&E asset, its cost in-
cludes all actual expenditures incurred through completion of construction,
even financing cost. What if a firm exchanges one of its assets plus some cash for
another, similar to an individual trading in an old car for a new one plus an
additional cash payment? The new asset is valued at its estimated cash price.
In general, firms try to match costs to the revenues that the expenses
helped produce. However, property (i.e., land) is recorded at cost and
then normally kept at cost. Why is the cost of land not matched to the rev-
enue it helps the firm produce? Because land is a unique geographic loca-
tion, a spot on the globe, and not thought to deteriorate or change over
time. Is the cost of land ever changed? Temporary changes in market value
are ignored because the market value of land, unlike an actively traded
2
Taken from the firms’ annual 10-K reports to the Securities and Exchange Comis-
sion (SEC).
Long-Term Assets 89
security, is highly subjective. However, if there is a permanent decline in

value, the firm will reduce the value on the Balance Sheet and recognize
a loss because of this reduction on the Income Statement. For example, if
a firm owned land beside an ocean, and the land eroded, the value would
have to be written down. Or perhaps the firm owns land in a foreign
country, which expropriates the land, then a loss must be recognized. Can
the value of land ever be increased above cost? Yes, it is possible by using a
mark-to-market valuation (discussed in Accounting for Fun and Profit:
Understanding Advanced Topics in Accounting), but it is very rare for
firms to choose this option.
The cost of plant and equipment (e.g., buildings and machinery) is
matched to revenue. How can you match the cost of an asset that lasts for
years to the revenue of a single year? There are two general approaches, both
somewhat arbitrary. One reduces the value evenly over time, whereas the
other has higher amounts in the early years and lower amounts in the
later years.
For example, imagine a firm purchases a car for $40,000 cash at the
start of its second year of operations (automobile up $40,000, cash down
$40,000). At the end of the year, the firm estimates (a management guess
based on experience) that the asset will be reduced evenly over say the
next 5 years from $40,000 at the start of year 2 to $10,000 at the end of
year 6. The annual reduction is $6,000 a year, and $10,000 is the “salvage
value” of the car, meaning the estimated sale value of the asset at the end
of its useful life. How do you know by how much to reduce plant or equip-
ment each year? This is computed by taking the initial cost of the asset less
the salvage value, with the difference being divided by the length of the
useful life. In our example, that would be the $40,000 initial cost minus
a $10,000 salvage value divided by 5 years. The annual reduction is called
depreciation if it relates to a tangible asset (one you can touch), depletion
if on a natural resource (e.g., a mine or timberland), and amortization if
on an intangible asset (e.g., a patent, copyright, and so on).
Annual Depreciation = (Cost − Salvage)/Life
This method is called straight-line depreciation because, as shown

in Exhibit 6.1, the value declines in a straight-line over time. This is by
Exhibit 6.1
Straight-line depreciation
50000
40000
30000
$
20000
10000
0
1 2 3 4 5 6
Year
far the most common method used by firms for financial reporting. It
is simple to compute and understand and has an income smoothing
effect.
A potential critique of the straight-line method is that it does not
match how the asset actually deteriorates over time. There are many dif-
ferent methods where the reduction is meant to match how the asset ac-
tually declines in value, with higher amounts in the early years and lower
amounts in the later years. These methods compute a rate which is ap-
plied to the undepreciated balance of the asset. The most popular of these
methods is called double declining balance because it creates an annual
rate using a numerator of 200 percent.
Annual Depreciation = (Cost − Accumulated Depreciation to date) ×
200%/Life of Asset
Using the same example as above, the rate would be 40 percent
(200%/5-year life). The depreciation in each of the 5 years is then com-
puted as:
Year 1 = $16,000 = the initial cost of $40,000 × 40%
Year 2 = $9,600 = the remaining balance of ($40,000 − $16,000) × 40%,
Year 3 = $5,760 = the remaining balance of ($24,000 − $9,600) × 40%,

Long-Term Assets 91
Exhibit 6.2
Double declining balance
50000
40000
30000
$
20000
10000
0
1 2 3 4 5 6
Year
Year 4 = $3,456 = the remaining balance of ($14,400 − $5,760) ×

40%, and
Year 5 = $2,074 = the remaining balance of ($8,640 − $3,456) × 40%
As shown in Exhibit 6.2, the graph has a steeper slope in the early
years and then levels off.
Note that the double declining balance method does not include a
salvage value in the computation because, implicitly, the ending value
after depreciation done in this way is the salvage value.3
It is important to note that neither of these methods is meant to value
the asset. Both are meant to match a cost to the revenue. The difference
between the methods is whether the cost is spread out evenly over time or
has a higher amount in the early years. In fact, the economic value of the
asset may be higher or lower than the accounting value. Unlike current
assets, long-term assets, such as plant and equipment, are not normally
adjusted up or down to market values. Accounting is relating the histori-
cal cost of the asset (i.e., what the firm incurred) to the revenues that the
asset helps the firm generate.
3
In some computations, the depreciation stops when the salvage value is met. For
example, assuming a salvage value of $10,000, the depreciation in year 3 would be
$4,400 and there would be no additional depreciation in years 4 and 5.
How does a firm estimate the life of an asset and its salvage value? As
with all estimates, past experience, industry averages, and management’s
beliefs are used here. Normally, the longest life used is 40 years. However,
there are many assets (e.g., buildings) that have lives much longer than
40 years. What happens when the asset lasts longer than the estimate used for
the depreciation? By incorrectly estimating the asset’s life at less than its
actual, a firm records too high a depreciation expense over the estimated
life and then nothing in the final years of the asset’s use. Once the asset is
reduced to its salvage value, the computation stops and there is no further
depreciation expense, even though the asset is still in use. This means that
all else equal, accounting profits in future years will be higher because
there is no longer a reduction from depreciation. Remember, depreciation
is an expense spreading the cost of an asset out over its useful, revenue-
generating life. If the asset is fully depreciated but is still in use, there is
no additional depreciation allocation for the original asset and the firm
does not yet have the depreciation cost of a replacement. However, it is
important to remember that what increases in this case is the accounting
(not economic) profit based on the accounting deprecation.
An Accountant in Paris
Once upon a time, (around 1990) there was a hypothetical large firm
located in the center of Paris, France. The firm had an accounting profit
of roughly $5 million4 a year, more or less, over the prior 10 years. Then,
the firm received an offer of $100 million for its 80-year-old plant. The
buyer did not really want the old dilapidated plant. The buyer wanted the
land the plant was on. The selling firm accepted the offer and built a new
state-of-the-art plant just outside Paris for $50 million. How much profit
(ignoring taxes) did the firm make in the year it accepted the offer? (Try to
answer before reading on.)
About $105 million. The firm probably still made the regular $5 mil-
lion, and it also had a gain of close to $100 million on the sale of the
old plant. The gain on the sale of the plant is the selling price less the
4
The original story had the firm earning 20 million French Francs, which have been
converted to US dollars.
Long-Term Assets 93
accounting value at the time of sale. Does it matter what the plant’s original
cost was 80 years ago? It does not matter because 80 years later, at the time
of sale, the accounting value would have been close to zero. The building
would have been reduced to zero (assuming there is no salvage value) on
the Balance Sheet 40 years earlier (e.g., the plant was 80 years old and
the longest depreciation period is normally 40 years). The only value on
the Balance Sheet would have been for the land, at its cost from 80 years
ago because land is usually kept at its original cost. The gain on the sale is
$100 million less the original cost of the land 80 years ago.
What about the purchase of the new plant? Does that not reduce the
profit? Yes, but only by the depreciation and only once the plant is in
operation. The accounting for the new plant is asset up $50 million, cash
down $50 million.
What is the profit the next year? (Again, try to answer before reading on.)
About $3.75 million. The firm probably made close to the $5 million
it made with the old plant, maybe a bit more if the new plant is more effi-
cient. However, the firm now has depreciation expense from the new plant.
The amount, using the straight-line method, would be the initial cost of
the plant divided by 40 years ($50 million/40), if we assume there is no sal-
vage value. This would mean a depreciation cost of $1.25 million per year.
The firm then fired its plant manager. According to the accounting
records, he had been making about $5 million a year with virtually no in-
vestment in PP&E. Then he had a spectacular year making $105 million
(21 times his prior 10-year average). This was followed by a truly horrible
year of only $3.75 million and this last profit was made after investing
$50 million in PP&E. This represents a meager return of 7.5 percent
($3.75/$50), well below what the firm could have earned by investing
in risk-free government bonds (in 1990 governments bonds were paying
well above 10 percent).
As with the “Accountant in Dallas” example in the prior chapter, ac-
counting is not about economic profit. The manager was not making an
economic profit of $5 million. There was an economic cost in using the
plant. Also, despite the accounting records showing virtually no invest-
ment in PP&E, the old plant did have a value (just not in the account-
ing records). Perhaps it was the wrong decision to build the new plant
because it provided insufficient returns.
Back to Accounting for PP&E

The accounting records will have a separate account for each long-term
asset, which the firm tracks. In fact, each long-term asset will have two
separate Balance Sheet accounts: one for the cost of the asset and one for
the total depreciation to date, which is called accumulated depreciation.
Note that the second account is a contra (or negative) asset account similar
to the allowance for doubtful accounts (ADA) attached to accounts receiv-
able. The accumulated depreciation account shows the total depreciation
taken from the date the assets were purchased through the Balance Sheet
date. Thus, the net accounting value of the asset is the cost less the ac-
cumulated depreciation account. The individual annual depreciation ex-
penses are temporary accounts on the Income Statement and are reset to
zero each year.
Using straight-line depreciation in the automobile example above, the
accounts would appear as follows in the first 3 years: net PP&E (cost
less accumulated depreciation) would be $34,000 ($40,000 − $6,000),
$28,000 ($40,000 − $12,000), and $22,000 ($40,000 − $18,000),
respectively.5
−Accumulated Retained Depreciation

Year Cash PP&E depreciation earnings expense5(I/S)
Year 1 −$40,000 +$40,000
+$6,000 +$6,000
−$6,000 −$6,000 reset
to 0
Year 2 +$6,000 +$6,000
−$6,000 −$6,000 reset
to 0
Year 3 +$6,000 +$6,000
−$6,000 −$6,000 reset
to 0
5
When the depreciation expense is reduced (reset) to zero at the end of the year (with
a credit), the retained earnings account (part of owners’ equity) is also reduced (with
a debit).
Long-Term Assets 95
−Accumulated Net year-end

Balance PP&E depreciation value
Year 1 $40,000 $ 6,000 $34,000
Year 2 $40,000 $12,000 $28,000
Year 3 $40,000 $18,000 $22,000
What happens if there is a change in an estimate? Changes are done

prospectively; there is no retroactive adjustment. Assume in our example
above that the firm realizes at the start of year 4 that the asset will last 4
more years (7 years in total) and have a final salvage value of $2,000. No
adjustment is made for years 1, 2, and 3. The numbers provided were the
best estimates at the time. However, at the start of year 4, the asset has an
accounting value of $22,000 (the cost of $40,000 less the accumulated
depreciation of $18,000). The straight-line depreciation for years 4 to 7
is calculated at $5,000 ([$22,000 − $2,000]/4). In other words, the firm
can recalculate depreciation for the additional years of useful life using the
asset’s accounting value at the time the firm discovered it had underesti-
mated its life. The formula can be restated as:
Annual Depreciation = (Accounting value − Salvage)/Remaining Life
Note that with double declining balance, the rate would be changed
to 50 percent (200%/4) applied to the remaining net balance (Cost −
Accumulated Depreciation).
Also note that the life does not have to be time related (years or
months). Other common examples would be machine hours (how many
hours will the machine be used before it is scrapped or sold) and miles
(how many miles will the car be driven before it is sold).
Furthermore, depreciation is normally prorated for assets purchased
during the year (e.g., if the asset was purchased on March 1 for a firm
with a calendar year-end, the first calendar year would have 10/12 of a
full year’s depreciation and the last calendar year would receive 2/12).6
6
At one point, to simplify the calculation, firms would, regardless of the actual date
the asset was placed into service, record a full year’s depreciation in the year of pur-
chase and nothing in the final year or alternatively record half a year’s depreciation in
the year of purchase and half a year’s depreciation in the final year. Today, with the ease
of computing the pro-rating it is hard to justify this practice.
Finally, as noted above, the concept of depreciation can be applied to

natural resources (called depletion) and intangible assets (called amortiza-
tion). For natural resources, the life would normally not be time but rather
the quantity of the estimated resource (trees for a timberland, barrels of oil
for an oil well, and so on). For intangibles, the life is normally time and
the maximum is the remaining life of the patent, copyright, and so on.
However, for intangibles, there is an additional wrinkle. If the firm
develops or creates the intangible (e.g., discovers a new medicine and pat-
ents it), there is often no cost to be reduced because the costs of research
and development (R&D) are normally expensed as they occur. This means
that firms usually only amortize intangibles when they have purchased
them whole from someone else (i.e., when there was an initial purchase
cost to amortize over time). Then it is cash down and asset up followed by
the reduction (amortization) matched to revenues. This is why some firms
like pharmaceuticals have losses for years followed by spectacular profits
(or bankruptcy); they do not spread the costs of R&D over time to match
revenues. By contrast, exploration for natural resources can be capitalized
(cash down, asset up) depending on the circumstances.
Other Noncurrent Assets

As with “other current assets,” these are miscellaneous items which by them-
selves are not large enough to merit their own line on the Balance Sheet. It can
include intangible items, long-term prepayments, and advances to officers.
The Bottom Line

Accounting tries to match expenditures on long-term assets to the revenues
these assets help produce, similar to how it tries to match uncollected receiv-
ables and inventory to revenues. To do so requires assumptions and estimates,
as well as a choice of accounting technique. This results in a less-than-perfect
match, and provides another example of why accounting numbers do not
reflect economic reality. Also, as will be discussed in Chapter 11 on cash
flows, it is useful to remember that it is the payment for the long-term assets
that cause a cash outlay, not the following depreciation expense.
The next chapter moves to the other side of the Balance Sheet and
examines short-term liabilities.
CHAPTER 7
Current Liabilities
The accounting for current liabilities may seem familiar because many
of the accounts are mirror images of those in current assets. With cur-
rent liabilities, a firm is on the opposite side of the transaction from that
of current assets. Instead of selling, using, or converting something to
cash within a year as it does with current assets, the firm has purchased
something and must pay for it within a year or has received prepayment
and must provide goods or services within a year. Current liabilities are
current obligations to transfer assets or provide services in the next year
and will generally be satisfied with current assets. Common examples of
current liabilities are discussed below.
Bank Debt
Bank debt is a short-term or revolving (automatically renewed) loan.
It can be thought of as negative cash. Most firms do not actually nego-
tiate short-term loans as they need them. A firm instead arranges a line
of credit from the bank before its actual funding requirements occur.
This allows the firm to make payments even when it has no available
cash in its bank account and without having to get a new loan ap-
proved each time—by prior agreement, the bank automatically lends
money to the firm up to a certain amount. The rate and terms are all
set in advance (the rate usually is a set percentage above what is called
the “prime rate”).1 Banks charge a fee for the line of credit, usually
1
The prime rate is a rate banks give their best customers. Currently it is about 3 per-
cent above the U.S. government discount rate. Depending on a firm’s product market
and financial situation, the company will pay anywhere from slightly below to well
above this rate.
falling around 30 basis points (i.e., 0.3 percent of the total possible
loan amount). The bank charges this fee simply for making the line
of credit available and regardless of whether the firm actually borrows
any funds (e.g., a firm would pay $3,000 a year to have a $1 million
line of credit open).
Current Maturity of Long-Term Debt

Loans to a firm from a public debt issue are often several years long. How-
ever, when such a long-term loan’s time to repayment is less than a year,
the long-term loan is reclassified as a current liability (e.g., if a 10-year
loan was issued 9 years ago, it will have to be repaid next year and thus
moves from being a long-term liability to a current one).
Payables
There are many different types of amounts firms have to pay based on
their operations. These amounts are called payables and include:
Accounts payable—amounts owed to suppliers of goods or services,

Wages payable—amounts owed to employees,
Taxes payable—amounts owed to the government for sales tax or in-
come tax, and
Dividends payable—amounts which the board of directors has de-
clared and set for payment to the owners (this will be discussed in
more detail in Chapter 10).
The accounting for payables is much simpler than its receivable

counterpart. This is because there is no need to estimate an allowance for
doubtful accounts payable; the firm does not estimate amounts it owes
that it will not pay.2 Thus, each of the items above represent what the
firm expects to pay in the coming year based on past transactions.
2
If a firm does indeed fail to pay, it is likely to be in financial distress and will have
greater problems than estimating allowances.
Current Liabilities 99
Advances from Customers and Unearned Revenue

When a firm receives funds for which it has not yet provided any goods
or services, or for which it has only provided part of the goods or services,
the firm has a liability to provide them in the future. The liability reflects
the total amount the customer(s) paid for the products or services to be
provided. Note that that this means the liability equals the firm’s cost to
provide the product or service plus its expected profit—the payable does
not equal the cost of producing the goods or services but rather reflects
the price the customer paid to the firm.
How would a customer’s advance payment be recorded? On the Bal-
ance Sheet, this would increase cash on the asset side (with a debit)
and increase unearned revenue on the liabilities side (with a credit). But
revenue would not be recorded on the Income Statement until the firm
had delivered the product or service to the customer. (As discussed in
Chapter 4, if the customer received part of the product or service order,
then revenue could be recorded for the part that was delivered to the
customer.)
Deferred Income Tax

Although the discussion of deferred income tax is included here, it could
in fact be included in current assets, noncurrent assets, or noncurrent
liabilities. When the deferral is expected to be reversed (i.e., when the
income tax cannot be deferred any longer and must be paid) determines
whether it is short-term or long-term. Whether it is a payment in ad-
vance or a delayed payment determines whether it is an asset or liability.
Until December 14, 2016, firms can have four different classifications
for deferred taxes: current assets, long-term assets, current liabilities, and
noncurrent liabilities. After they must be classified as noncurrent.
Deferred taxes arise when a firm’s publicly reported financial
statements do not match its tax returns. Remember, it is perfectly
legal in most countries for firms to make different accounting choices
(e.g., to recognize revenues or match expenses) for public reporting
and tax purposes. The accounting policies for public reporting are
supposed to reflect the underlying economics of the firm, at least
in some sense.3 On the other hand, the accounting choices for tax
policy are designed to optimize tax payments, which normally means
delaying them because, all else equal, a firm would rather pay the
government later.
The deferred tax account represents a difference in how tax expense is
matched to income and how taxes are actually paid. Let us therefore look
at how tax expenses are recorded before examining how deferred taxes are
recorded.
For example, imagine a firm with public reporting that shows profit
before tax of $100 million a year for 3 years (a total of $300 million over
the 3 years), whereas taxable income is reported to the government at
$80 million, $100 million, and $120 million (still totaling $300 million
over the 3 years). Further assume the corporate tax rate is 30 percent.
The actual taxes paid are 30 percent of the taxable income that the firm
reported to the government, which means $24 million, $30 million, and
$36 million for a total of $90 million over the 3 years.
How does the firm record the taxes paid to the government? As will be
shown in more detail with step-by-step journal entries below, the pay-
ments are reflected on the Balance Sheet (either as a decrease in cash or an
increase in an amount owed to the government) with some corresponding
expense on the Income Statement. You might think that the firm should
have the tax expense recorded on the Income Statement equal the amount
actually paid or owed in taxes.4 However, remember that accountants try
to match expenses (costs) to revenue. Recording $24 million, $30 mil-
lion, and $36 million as the tax expenses over the 3 years, as shown in
Exhibit 7.1, would do a poor job of matching the tax expense to the rev-
enue. The firm’s revenue was the same every year, so the best way to match
3
Although the accounting policies for public reporting are supposed to reflect the un-
derlying economics, as prior chapters discussed, the firm can choose to have more of a
Balance Sheet approach (which more accurately reflects the value of its assets) or more
of an Income Statement approach (which is a better predictor of future cash flows).
4
For simplicity, tax paid is the taxable income times the tax rate. In fact, the taxes are
not all paid by year-end, so the taxes owed for the year would have been partly paid
and there would be a short-term liability of taxes payable for the difference.
Exhibit 7.1
Comparison of tax expenses based on payment vs. rate
(millions) Year 3 Year 2 Year 1 Total
Taxable income $120 $100 $ 80 $300
Tax rate 30% 30% 30% 30%
Taxes paid $ 36 $ 30 $ 24 $ 90
Poorly matched Year 3 Year 2 Year 1 Total
Public reported profit before tax $100 $100 $100 $300
Tax expense based on taxes paid $ 36 $ 30 $ 24 $ 90
Net profit based on taxes paid $ 64 $ 70 $ 76 $210
Properly matched Year 3 Year 2 Year 1 Total
Public reported profit before tax $100 $100 $100 $300
Tax expense based on tax rate $ 30 $ 30 $ 30 $ 90
Net profit based on tax rate $ 70 $ 70 $ 70 $210
tax expenses to revenues would be to apply the 30 percent tax rate to each
year’s public reported profits of $100 million.
A couple of notes: First, in the example above, the public reported
income was the same in all 3 years. This does not have to be true for the
example to be valid. Second, in this example, the difference completely
reverses out over 3 years because the 3-year totals are the same for both tax
and public reporting. In reality, reversals can take a very long time, even
decades, and while one tax deferral reverses others may be set up, causing
the total deferred tax to grow.
What causes the differences in public and tax reporting? There are in fact
two types of differences in a firm’s public and tax reporting of revenues
and expenses. Some are permanent (i.e., certain revenues and expenses
are never included in tax reporting) and some are temporary (i.e., the
firm recognizes revenues or expenses in a different year for public report-
ing and tax purposes). The permanent ones impact the firm’s effective
tax rate and have no effect on the difference between taxes paid and tax
expense described in Exhibit 7.1. The temporary ones reverse out over
time and cause the matching problems between tax paid and tax expense
described above.
Permanent differences reduce the amount included as taxable reve-

nues (e.g., interest earned on municipal bonds are never taxed for federal
purposes) and taxable expenses (e.g., certain fines and penalties are never
deductible for tax purposes). For example, assume a firm has revenue of
$100 million and total expenses before tax of $80 million for a net profit
before tax of $20 million and there are no temporary differences (i.e., the
firm’s tax payment and tax expense will match). If the tax rate is 35 per-
cent, the firm will have a tax expense of $7 million and net profit of $13
million ($20 million in profit before tax less $7 million in tax expense).
Now assume $1 million of revenue is not taxable for one reason or an-
other (a permanent difference). This means the firm has $99 million of
taxable revenue (the amount reported to the government) with its same
$80 million of taxable deductions, resulting in a taxable profit of $19
million. The firm pays tax of 35 percent on the $19 million, which equals
$6.65 million. For public reporting purposes, the firm still shows total
revenue of $100 million and total expenses of $80 million. However,
now the firm shows a tax expense of $6.65 million on profit before tax of
$20 million, and this represents an effective rate of 33.25 percent ($6.65
million of tax expense / $20 million of profit before tax). There are no
matching problems as the $6.65 million tax expense is what is owed and
paid. In a nutshell, if any part of a firm’s revenue or expenses are not tax-
able, it has the same effect as changing the tax rate.
Temporary differences (i.e., those that reverse out) occur due to the tim-
ing of when revenues and expenses are recognized for public reporting and tax
purposes. Probably the single largest of these is the depreciation on property,
plant, and equipment (PP&E) (see Chapter 6). In the United States, firms are
allowed to use different depreciation methods for public and tax reporting,
with most firms depreciating their plant and equipment faster for tax pur-
poses than for public reporting purposes. Even when firms use double declin-
ing balance (as opposed to the more common straight-line method) for public
reporting purposes, the tax method often still has a higher depreciation rate.
Extending the example above, Exhibit 7.2 assumes that, for both tax
and public reporting, the firm earns $140 million before depreciation and
tax. The firm has one long-term asset costing $120 million with a 3-year
life and no salvage value. For tax purposes, the depreciation is $60 million
in year 1, $40 million in year 2, and $20 million in year 3 (a total of
Exhibit 7.2
Taxable vs. public reported depreciation
Profit before depreciation and tax $140 $140 $140 $420
Tax depreciation $ 20 $ 40 $ 60 $120
Taxable income $120 $100 $ 80 $300
Tax rate 30% 30% 30% 30%
Taxes paid $ 36 $ 30 $ 24 $ 90

Public reporting depreciation $ 40 $ 40 $ 40 $120
Public reported income $100 $100 $100 $300
$120 over the 3 years), netting the taxable income shown in Exhibit 7.2
(i.e., $80 million, $100 million, and $120 million). For public reporting
purposes, the depreciation is $40 million a year (the $120 million depre-
ciated evenly over the 3 years), netting the public reporting profit before
tax shown in Exhibit 7.2 (i.e., $100 million each year).
As seen in Exhibit 7.2, the firm has a difference between tax paid (or
payable) and tax expense.5 This results in deferred tax in the public finan-
cial statements.
The journal entries would be as follows

Year 1 Tax expense $30 million
Cash $24 million
Deferred tax $ 6 million
Cash $30 million
Cash $36 million
5
For simplicity, it is assumed that all taxes are paid during the year. In reality, only
some portion of total taxes would be paid during the year leaving a tax payable at the
end of the year, that would be paid the following year.
A spreadsheet would show (millions)

Deferred tax
Year Cash liability Tax expense
1 −$24 +$6 +$30
2 −$30 +$30
3 −$36 −$6 +$30
In the example above, the deferred tax is initially classified as a

long-term liability. The example assumes that the deferred tax will be paid
(i.e., will reverse out) in year 3, so at the end of year 2, it becomes a cur-
rent liability.
Why would the government allow firms to use different accounting
choices for tax reporting that allow them to defer tax payments? Govern-
ment tax policy is complex and well beyond the scope of this book.
However, governments often provide firms with incentives to invest
and to create employment (which helps keep the government officials
in power). Allowing a higher depreciation rate for tax purposes is a
somewhat hidden tax subsidy. The government sets the allowed depre-
ciation rates for various types of plant and equipment based on how
much the government wants to encourage firms to purchase these as-
sets. For example, a government could allow a 100 percent write-off
(full depreciation in the year of purchase) for the cost of solar panels,
whereas for public reporting purposes, the firm would depreciate the
panels over their expected useful lives, which is currently estimated at
about 20 years.6
There are cases where the firm will record revenues sooner or expenses
later for tax purposes. For example, in Exhibit 7.3, the firm records a $40
million depreciation expense a year for 3 years for tax purposes and $60
million, $40 million, and $20 million for public reporting purposes.
The deferred tax becomes an asset instead of a liability because the firm
is paying the government sooner rather than later.
6
Solar panels placed into service by December 31, 2011, could be 100 percent depre-
ciated in 1 year. Certain qualifying equipment placed into service by December 31,
2013, had a 50 percent “bonus” depreciation. Currently, the U.S. government allows
solar panels to be depreciated over 5 years.
Exhibit 7.3
Taxable vs. public reported depreciation
Tax depreciation $ 40 $ 40 $ 40 $120
Taxable income $100 $100 $100 $300
Tax rate 30% 30% 30% 30%
Taxes paid $ 30 $ 30 $ 30 $ 90

Public reporting depreciation $ 20 $ 40 $ 60 $120
Public reported income $120 $100 $ 80 $300
The journal entries would be as follows

Deferred tax $ 6
Cash $30 million
Cash $30 million
Cash $30 million
A spreadsheet would show (millions)

Deferred
Year Cash tax asset Tax expense
1 −$30 +$6 +$24
2 −$30 +$30
3 −$30 −$6 +$36
Deferred tax can be thought of as an interest-free loan from the govern-

ment (if it is a liability) or to the government (if it is an asset). As shown above,
using a higher initial depreciation for tax purposes (as opposed to using the
same expense as it had for public reporting purposes) allows (as shown in
Exhibit 7.2) the firm to delay a $6 million payment from year 1 to year 3.
Note that there is in fact a separate deferred tax account for each item with
a timing difference. In most cases, the firm will have lower revenues or higher
expenses for tax purposes, resulting in a deferred tax liability. Firms normally
net the current deferred tax asset and liability and net the long-term deferred
tax asset and liability, resulting in one current item and one long-term item.
What if there is a change in the tax rate? Does this affect deferred taxes?
Yes, but only when enacted into law—proposed tax changes are ignored.
Once a tax rate is changed, the timing difference is multiplied by the new
rate, the deferred tax is adjusted, and the impact of the rate change either
increases (if the rate went up) or decreases (if the rate went down) the
current year’s income tax expense.
Assume that in our example above, the income tax rate decreased from
30 percent to 20 percent prospectively at the end of the second year, which
means that the change in rate will be applied to year 3 but not year 2. The
timing difference at the end of year 2 is $20 million as before (the cumulative
depreciation for tax purposes is $60 million + $40 million = $100 million
vs. the cumulative depreciation for public reporting purposes is $40 million
+ $40 million = $80 million). The deferred tax is $6 million based on the
$20 million difference times 30 percent. However, because of the change in
the law, when the reversal occurs it will now be only $4 million (the $20 mil-
lion times the new rate of 20 percent). In year 2, the deferred tax would have
to be lowered (the benefit of the lower rate is recognized) by $2 million (from
$6 million to $4 million), and the tax expense would be reduced by $2 mil-
lion (from $30 million to $28 million). In year 3, the tax expense is now based
on the lower rate, and the deferred tax already adjusted in year 2 is reversed.
Using journal entries

Cash $24 million
Cash $30 million
Cash $24 million
Using a spreadsheet (in millions)

Deferred tax
Year Cash liability Tax expense
1 −$24 +$6 +$30
2 −$30 −$2 +$28
3 −$24 −$4 +$20
If the tax rates went up instead of down, the opposite would occur
and the deferred tax liability and the tax expense would be increased. The
benefit or future cost is adjusted in the year the tax change is enacted into
law and then the new rate is applied in future years.
One final tax-related issue has to do with how tax losses are treated.
If a firm does not have any profits for tax purposes, it pays no taxes. But
what if a firm has losses? Does it get a tax break? It depends. In the United
States, a firm can normally apply losses in the current year against profits
from the prior 2 years and recover taxes paid through a refund by the gov-
ernment. This means that in a year in which a firm records a loss before
tax (i.e., negative profit before tax), the firm may show recoverable taxes
that reduce the net loss after tax. Of course, this only happens if the firm
had profits and paid taxes in the prior 2 years. If a firm had no profits
in the prior 2 years, or the losses in the current year are greater than the
profits of the prior 2 years, the loss (or unused portion of the loss) can be
applied (“carried forward”) against future profits for a set number of years
(currently 7 years in the United States). This means the firm will pay no
taxes until it earns back the amount lost.
Can the value of not paying taxes in the future be included in the current
financial statements? Sometimes. For example, a tax loss carryforward can be
applied against deferred tax liabilities. This is done by reducing the current
year’s net loss on the Income Statement (with a tax recovery line on the In-
come Statement) and reducing the deferred tax liability on the Balance Sheet.
Deferred tax liability (Balance Sheet account)

Tax loss recovery (Income Statement account)
It is also possible in some situations (where a firm has a proven track

record and is confident that it will have future profits before the tax loss
carryforward expires) to record the tax loss carryforward as an asset and

reduce losses in the current year (with the same tax recovery line on the
Income Statement and setting up a deferred tax asset on the Balance
Sheet).
Deferred tax asset (Balance Sheet account)

Tax loss recovery (Income Statement account)
Despite the complexity in the actual calculations, from the reader’s

perspective, deferred tax liabilities should be thought of as interest-free
loans from the government and deferred tax assets as interest-free loans
to the government.
As an aside, one of the largest deferred tax liabilities must be that of
the ExxonMobil Corporation, which had a long-term net deferred tax
liability of $36.8 billion on December 31, 2015. If Exxon’s cost of debt
is 4 percent, this represents an implicit tax subsidy of almost $1.5 bil-
lion a year, or 27.8 percent of the $5.4 billion Income Tax Expense that
Exxon reported on its public Income Statement. (Remember, by defer-
ring this amount in taxes, Exxon can use the funds that it would have
otherwise given the government and will not have to take out a loan,
which means Exxon is avoiding the 4 percent interest it would have been
charged on a loan.) The firm’s notes detail the deferred tax liability, which
on PP&E alone is a staggering total of $49.4 billion. However, Exxon’s
deferred tax liabilities are offset somewhat by its significant deferred tax
assets (these are related to the firm’s pensions and other assets) for a net
of $36.8 billion.
Other Liabilities
This category includes a host of other items that, as with “other assets,” are
not large enough in amount to merit their own line on the Balance Sheet.
(Though if they are material for an individual firm, then they should be
disclosed separately in their own line.) This includes items such as:
Returnable deposits—this includes a deposit for goods or services

where the customer has not made a firm commitment to purchase,
or for an amount that will be returned based on the customer’s ac-

tions. For example, supermarkets often add a refundable deposit
on soft drink sales. When the customer returns the container, the
supermarket refunds the deposit.7
Estimated warranties—firms that provide warranties on their

products must estimate the cost of providing the future services
under the warranty and then set up the related expense and liabil-
ity in the period of the sale.
Accrued expenses—this category includes all year-end minor ex-

penses, which the firm has incurred but not yet paid. One com-
mon example is the unpaid partial monthly bill for utilities (e.g.,
if the firm’s fiscal year-ends on December 31 but its last utilities
bill runs from December 14 to January 13, then the firm will not
have received a bill for December 31 and will have to record the
unpaid partial bill for December 14 to 31 in its financial state-
ments for the year).
The Bottom Line

Current liabilities are a mirror image of current assets. Bank debt can
be thought of as negative cash. Payables are amounts owed to suppliers
of goods and services. Unearned revenue reflects payments received in
advance of providing goods or services. Deferred income tax (which can
be an asset or liability, short or long-term) is the cumulative difference
in taxes paid and payable versus those expensed (matched to income). A
deferred tax liability (asset) can be thought of as an interest free loan to
(from) the government.
The next chapter describes how to value future cash flows.
7
In most cases, after some period of time, unclaimed amounts are given to the
government.
CHAPTER 8
The Time Value of Money

Discounting and Net Present Values1
This chapter deals with compounding and discounting. For students of
accounting, it is a critical component in understanding long-term liabili-
ties. After the basics are presented, the chapter will discuss how to value
annuities (equal periodic payments), bonds (debt obligations), and perpe-
tuities (payments that continue forever).
The Time Value of Money

The time value of money is one of the most powerful concepts in finance.
It is a concept that small children express when they say, “I want it now,
not later, now!” Quite simply, the idea is that a dollar today (or anything,
for that matter) is worth more than a dollar tomorrow.
An easy way to start the explanation of the time value of money is to
consider a bank account. If you invest $100 in a bank account at the start of
the year and earn 5 percent annual interest on your funds during the course of
the year, how much will you have at the end of the year? You will have $105,
which is your original deposit of $100 plus the interest of $5 that you
earned during the year ($100 × 5%). This means that with a 5 percent
interest rate, $100 today is equivalent to $105 in a year. Conversely, $105
in a year is worth $100 today at that interest rate.
Taking an amount today and computing what it will be worth in
the future is called compounding. Taking an amount in the future and
1
Part of this chapter is copied from Asquith and Weiss: Lessons in Finance © 2016.
Reprinted with permission.
figuring out what it would be worth today is called discounting. Com-

pounding and discounting are inverses of each other.
What if you leave the $105 in the bank for a second year, again earn-
ing 5 percent? How much would you have at the end of the second year?
You would have $110.25. You start the second year with $105 and earn
an additional $5.25 of interest during the second year ($105 × 5%).
You earned more in interest during the second year ($5.25) than in
the first year ($5.00) because you began the second year with more
money. In the second year, you earned $5 interest on the original $100
plus an additional $0.25, which is 5 percent interest on the $5 that
you earned the first year. In the second year, you are earning interest
on your interest. This example also means that $110.25 in 2 years is
worth $100 today.
We can represent the above visually with the following time line:
$100 $105.00
$ 5 $ 5.25
$100 × 5% = $5 $105 ×5% = $5.25 $110.25
|-------------------------------------|---------------------------------|
Today End year 1 End year 2
We will consider today to be the present, so the $100 is our present

value (or PV for short). The $105 value is a future value (FV), as is the
$110.25. To differentiate between the two, we call the $105 the FV at
time 1 (FV1) and the $110.25 the FV at time 2 (FV2). We can relabel our
time line as follows:
$100 × 5% = $5 $105 ×5% = $5.25 $110.25

|------------------------------------|---------------------------------|
PV FV1 FV2
The 5 percent is our interest rate, denoted as r (also sometimes de-

noted as i). This allows us to put our time line into a formula:
FV1 = PV × (1 + r) $105.00 = $100 × (1 + 5%)

FV2 = FV1 × (1 + r) $110.25 = $105 × (1 + 5%)
THE TIME VALUE OF MONEY 113
We use algebraic substitution to get:
FV2 = FV1 × (1 + r) = PV × (1 + r) × (1 + r) = PV × (1 + r)2
In the above example, $110.25 = $100 × (1.05)2

We can generally write that for any future period n:
FVn = PV × (1 + r)n
where, at an interest rate of r per period, the FV n periods from now is

equal to the current value times (1 + r)n.
This compounding of a PV into a FV is a concept familiar to most, in-
cluding those not involved in finance. We encounter this regularly when
we put money in the bank and collect interest.
Discounting a FV to a PV is usually new to those unfamiliar with fi-
nance. It is, however, as noted above, the inverse of compounding. Math-
ematically, it works as follows:
We divide both sides of the equation FVn = PV × (1 + r)n by (1 + r)n
to get the PV:
PV = FVn / (1 + r)n
Using the numbers from our example above, discounting FV2 of

$110.25 backward for 2 years at an interest rate of 5 percent gives us
$100 today.
PV = $110.25 / (1.05)2 = $100
That is it. This is the essence of compounding (going forward), dis-

counting (bringing backward), and the time value of money. We will now
apply this concept to different situations.
More on Compounding and Discounting

Let us use another example to illustrate compounding and discounting.
Imagine you are offered a lump sum payment of $12,000 today (Op-
tion 1) or $18,000 at the end of 4 years (Option 2) and that your yearly
interest rate is 8 percent.2 Which is worth more: the $12,000 today or the
$18,000 in 4 years?
To answer this, we have to choose one date and then compare the value of
the two options on that date (it can be any date: today, at the end of 4 years,
or any date in between). Let us start by finding the value of the two options
at the end of 4 years. By definition, Option 2 is $18,000 in 4 years. What is
the value of Option 1 in 4 years? That is, how much is $12,000 today worth in 4
years? From our equations above, with PV = $12,000, r = 8%, and n = 4.
FVn = PV × (1 + r)n = $12,000 × (1.08)4 = $16,325.87
It is therefore better to choose the lump sum of $18,000 in 4 years

than to take the $12,000 today and invest it at 8 percent for 4 years.
To repeat, taking the $12,000 today and computing its FV is called
compounding. Visually:
$18,000.00 (Option 2)
vs.
$12,000 r = 8% $16,325.87 (Option 1)
|----------------------|------------------|------------------|-------------|
0 1 2 3 4
We can also answer the question of which option is worth more by
comparing the two options today. By definition, the value of Option
1 is $12,000 today. What is the value of Option 2 today? That is, how
much is $18,000 in 4 years, worth today? Using our equation above with
FV = $18,000, r = 8%, and n = 4.
This has a PV = $18,000 / (1.08)4 = $13,230.54
Taking the $18,000 in the future and computing its value today is
called discounting.
Visually:
(Option 1) $12,000.00
vs.
(Option 2) $13,230.54 r = 8% $18,000
|----------------------|------------------|------------------|-------------|
0 1 2 3 4
2
In a business context, this is equivalent to investing $12,000 today and receiving
$18,000 in 4 years (the original $12,000 plus interest). The “appropriate” interest rate
reflects the risk of the investment, which includes inflation.
It is important to note that compounding Option 1 to calculate

its FV and discounting Option 2 to calculate its PV both reveal that
the $18,000 in 4 years is worth more than $12,000 today. The results
are the same regardless of which direction we go (calculating the FV
or the PV).
Thus by using compounding and/or discounting, we can take two dif-
ferent options and compare them at the same point in time, and we will
get the same answer as to which has more value. The results are consistent:
The PV of Option 2 is greater than the PV of Option 1 and the FV of
Option 2 is greater than the FV of Option 1.
The Periodic Interest Rate

When talking about interest rates and compounding, it is important to
be clear about the period being used. In the examples above we assumed
the interest rates were for 1 year, which means that they were applied
once a year at the end of each year. However, it is quite common to have
an interest rate compounded more than once a year. A common example
in the United States is that most bonds pay interest (or coupons) twice a
year. This means that the compound rate is the stated (or annual) rate on
the bond divided by two.
Let us consider a U.S. bond with an 8 percent stated interest rate that
is compounded twice a year. This means the bond actually pays 4 per-
cent every 6 months. The 4 percent paid every 6 months is more than 8
percent paid once a year. Why? If the bond’s original cost is $100, then
at the end of the first 6 months it earns $4 in interest (4% × $100). The
interest for the second 6 months is again 4 percent, but this time it would
be 4 percent of $104, which equals $4.16. If the bond matures at the
end of the year, an investor would get back the original $100 cost (called
the “principal”) plus combined interest of $4 and $4.16 for a total of
$108.16. If the bond paid interest only once a year, to receive the same
year-end amount would require a rate of 8.16 percent.
Thus, the actual (or effective) interest rate over a period depends on
how often the interest is compounded.
In the example above, $12,000 with an 8 percent stated interest rate
compounded annually, gave us a total of $16,325.87 in 4 years. If the ex-
ample is changed and the $12,000 now has a stated interest rate of 8 percent
compounded quarterly, the computation is 2 percent every 3 months (i.e.,

the stated 8 percent rate is divided into four quarters or 2 percent each
quarter). If we want to find how much the $12,000 is worth in 4 years when
compounding quarterly, then r is the 2 percent rate and n is 16 (remember,
n is the number of periods, our periods in this example are quarters, and
there are 16 quarters in 4 years).3
Our computation is now:
FVn = PV × (1 + r)n
FV16 = $12,000 × (1.02)16 = $16,473.43
Note that FV16 at 8 percent compounded quarterly over 4

years ($12,000 × (1.02)16) gives us more than the $16,325.87 (or
$12,000 × (1.08)4) calculated above where compounding was done annually.
We can use this concept to generate a once-a-year equivalent interest
rate, called the annual percentage rate (APR), which is useful in compar-
ing interest rates that compound over different intervals.4
The formula to convert compounding more than once a year to an
APR is:
APR = (1 + r / j)n j − 1,
where j is the number of times a year interest is compounded.
Annuities
An annuity is a contract with equal periodic payments. Importantly, de-
spite the name of “annuity,” the periods do not have to be annual. Home
mortgage payments are a type of annuity (a large sum is borrowed, and
then equal monthly payments are made for the next 10, 20, or 30 years).
Also, most debt contracts are the combination of an annuity (the periodic
interest payment) as well as a final lump sum repayment.
3
There is no reason that the rate could not be stated for a time period of less than a
year (e.g., 2 percent every 3 months). It is simply convention to state the rate for a
year, which then has to be divided by the number of times it is compounded during
the year.
4
It is also called the annual percentage yield (APY) that readers may recognize from
their credit cards or mortgages.
Note, there are tables that provide the PV or FV of annuities. Today,

these have been replaced with computer spreadsheets where the value of
an annuity can be found by simply putting each payment into a cell of the
spreadsheet and discounting or compounding it.
Let us look at ordinary annuities first and then at annuities due. An
ordinary annuity is when the payments are made at the END of each
period and an annuity due is when the payments are made at the START
of each period.
As an example: Assume an equal payment of $300,000 is made at
the end of June and December for 2 years, with the first payment in
June 2014. Also assume an interest rate of 12 percent compounded
semiannually (i.e., 6 percent every 6 months or an APR of 12.36 per-
cent5). What is the value on January 1, 2014? The answer would look
as follows:
$300,000 $300,000 $300,000 $300,000

|-----------------------|---------------------|-------------------|-----------------|
1/1/2014 6/30/2014 12/31/2014 6/30/2015 12/31/2015
PV r = 6% / 6 months FV
$1,039,532
Date of payment Payment Discount Value Value

June 30, 2014 $300,000 1/(1 + r) 0.943396226 $ 283,019
December 31, 2014 $300,000 1/(1 + r)2 0.889996440 $ 266,999
June 30, 3015 $300,000 1/(1 + r)3 0.839619283 $ 251,886
December 31, 2015 $300,000 1/(1 + r)4 0.792093663 $ 237,628
Value 1/1/14 (r = 6%) $ 1,039,532
The above can also be computed by taking out the equal periodic pay-
ment and multiplying by the sum of the values as follows:
FV4 = $300,000 × [1 / (1.06)1 + 1 / (1.06)2 + 1 / (1.06)3 + 1 / (1.06)4]

FV4 = $300,000 × [0.9434 + 0.8900 + 0.8396 + 0.7921]
FV4 = $300,000 × 3.4651 = $1,039,530 (difference of 2 is due to rounding)
5
Apply the formula APR = (1 + r / j)n × j − 1. In this case, (1 + 12% / 2)1 × 2 −
1 = 12.36%.
How much would the firm have to pay on January 1, 2014, to eliminate
the debt (e.g., a lump sum, one-time payment instead of the four $300,0000
payments) if the discount rate is 12 percent compounded semiannually (or 6
percent every 6 months)? The answer is $1,039,532.
Alternatively, how much would the firm have to pay on December 31,
2015, to eliminate the debt (e.g., a lump sum, one-time, payment instead of
the four $300,0000 payments) if the discount rate is 12 percent compounded
semiannually (or 6 percent every 6 months)? The answer is $1,312,385.
$300,000 $300,000 $300,000 $300,000

|-----------------------|---------------------|---------------------|-------------------|
1/1/2014 6/30/2014 12/31/2014 6/30/2015 12/31/2015
PV r = 6% / 6 months FV
$1,312,385
Date of payment Payment Compound Value Value

December 31, 2015 $ 300,000.00 1 1.00 $ 300,000
June 30, 2015 $ 300,000.00 (1 + r) 1 1.06 $ 318,000
December 31, 2104 $ 300,000.00 (1 + r) 2 1.1236 $ 337,080
June 30, 2014 $ 300,000.00 (1 + r) 3 1.191016 $ 357,305
Value 12/31/15 (r = 6%) $ 1,312,385
Alternately, the total FV at the end of the annuity in December 2015

can be computed as follows:
FV = $300,000 × [1 + (1.06)1 + (1.06)2 + (1.06)3] =
FV = $300,000 × [1 + 1.06 + 1.1236 + 1.191016] =
FV = $300,000 × 4.374616 = $1,312,385
Note that once you know the FV, you can discount it to get the PV,
and once you know the PV, you can compound it to get the FV:
$1,039,532 ×1 / (1.06)4 $1,312,385

|----------------------------------|--------------------|---------------------|-------------------|
1/1/2014 6/30/2014 12/31/2014 6/30/2015 12/31/2015
$1,039,532 ×(1.06) 4 $1,312,385
An important caveat when using the discounting computation:
CORRECT: 1 / (1 + r)1 + 1 / (1 + r)2 + 1 / (1 + r)3 + . . . + 1 / (1 + r)n
This is NOT the same as:
INCORRECT: 1 / ((1 + r)1 + (1 + r)2 + (1 + r)3 + . . . + (1 + r)n)
An Ordinary Annuity vs. an Annuity Due

The presentation above is for an ordinary annuity. As stated, an “ordi-
nary” annuity is one with periodic payments made at the END of each
period and the final payment is on the FV date.
In contrast, an annuity “due” is one with payments made at the
START of each period and the first payment is made on the PV date and
the last payment is one period prior to the FV date (above it would be
January 1, 2014, June 30, 2014, January 1, 2015, and June 30, 2015).
Let us compare an ordinary annuity and an annuity due where each
have four payments of $300,000 as in the example above. Our timelines
would look as follows:6
Ordinary annuity:
$300,000 $300,000 $300,000 $300,000
|---------------------------|--------------------|-------------------|---------------------|
1/1/2014 6/30/2014 12/31/2014 6/30/2015 12/31/2015
$1,039,532
Annuity due:
$300,000 $300,000 $300,000 $300,000
|------------------------------|--------------------|--------------------|-------------------|
1/1/2014 6/30/2014 1/1/20156 6/30/2015 12/31/2015
$1,101,904
Does an ordinary annuity or an annuity due have a higher PV? As

shown, by discounting all the payments, the annuity due is worth more
($1,101,904) than the ordinary annuity ($1,039,532). Notice that both
6
A one-day difference, December 31, 2014, and January 1, 2015, is ignored (i.e., the
one-day interest on $1 million at 5 percent is about $137).
have three payments at the same time (June 30, 2014; December 31,
2014; and June 30, 2015). The difference between the two annuities is
that the annuity due’s four payments start with a payment on the PV
date of January 1, 2014, whereas the ordinary annuity’s first payment is
6 months later on June 30, 2014. Thus, the difference is the value of one
payment today (in this case on January 1, 2014) vs. one payment at the
end (in this case on December 31, 2015).
How much is a payment of $300,000 made on January 1, 2104, worth
on January 1, 2014? It is worth exactly $300,000.
How much is a payment of $300,000 made on December 31, 2015,
worth on January 1, 2014? It is worth $237,628 (using our formula, that
would be PV = FV4 / (1 + r)4 = $300,000 / (1.06)4 = $237,628).
The difference in the value of an annuity due and an ordinary annu-
ity in the above example is: $300,000 − $237,628 = $62,372. This is
the same result as comparing the total of the annuity due and the total of
the ordinary annuity ($1,101,904 − $1,039,532 = $62,372) because all
other payments are identical.
This means that, at any positive interest rate, an annuity due is worth
more than an ordinary annuity (e.g., receiving a payment on January 1,
2014, is preferred over receiving a payment on December 31, 2015).
Does an ordinary annuity or an annuity due have a higher FV? Think
about this for a moment. It is the same answer as above: The annuity due
(which has its first payment on January 1, 2014) compounds more interest
than the ordinary annuity (which has its first payment on June 30, 2014).
Remember that the math has to equate. Discounting (going back to
the present) or compounding (going forward to the future) has the same
answer of which annuity is better. Let us find the exact difference in val-
ues to prove it. In the previous example, the ordinary annuity has a pay-
ment of $300,000 on the future date of December 31, 2015. At the FV
date of December 31, 2015, that payment is worth $300,000. On the
other hand, the annuity due has a $300,000 payment on January 1, 2014.
On December 31, 2015, the annuity due’s first payment will be worth
$378,743 (because $300,000 × (1.06)4 = $378,743). Thus, comparing
the FVs of these two payments, ordinary annuity ($300,000) and of the
annuity due ($378,743), shows us that the annuity due is worth $78,743
more on December 31, 2015, over the ordinary annuity.
Just to close the math loop, note that the annuity due was worth
$62,372 more on January 1, 2014, and $78,743 more on December 31,
2105. These two numbers equate: the PV of $78,743 is $62,372, and the
FV of $62,372 is $78,743.
Most car leases are set up as annuity dues with 3 or 4 years of equal
monthly payments and the first one due at signing (and often some ad-
ditional up-front charges). Why are car leases set up as annuity dues? Be-
cause the annuity due is worth more? Not necessary, it all depends on the
payments. Although the deal can be set in multiple ways, let us focus
on three: a lump sum payment at the start (the cash price of the car), an
annuity due, or an ordinary annuity. The lump sum payment at the start
means the buyer is paying the full cost of the car at the beginning and
no future payments are owed. Let us set the cost of the car at a specific
amount and examine the difference in paying with an annuity due vs. an
ordinary annuity.
What are the periodic payments in our example if the one-time cash pay-
ment today (i.e., the purchase price) is $22,038? If the payments are made
at the start of the year using an annual percentage yield (APY) of 12.36
percent (which means 12 percent compounded semiannually), then the
annuity due would have four equal payments of $6,000 (on January 1,
2014; June 30, 2014; January 1, 2015; and June 30, 2015) and the or-
dinary annuity would have four equal payments of $6,360 (on June 30,
2014; December 31, 2014; June 30, 2015; and December 31, 2015).
How do we calculate the periodic payments of $6,000 for the annuity
due option and $6,360 for the ordinary annuity option? We use the formula
above but this time solve for an unknown payment to equal the PV (pur-
chase price) of $22,038.
Annuity due:
$22,038
Pmt = $Y Pmt = $Y Pmt = $Y Pmt = $Y
|---------------------------|--------------------|--------------------|-------------------|
1/1/2014 6/30/2014 1/1/2015 6/30/2015 12/30/2015
$22,038 = $Y × [1 + 1 / (1.06)1 + 1 / (1.06)2 + 1 / (1.06)3]

$22,038 = $Y × [1 + 0.9434 + 0.8900 + 0.8396] = $Y × 3.673
Which gives us $22,038 / 3.673012 = $6,000 = Y

Ordinary annuity:
$22,038
Pmt = $X Pmt = $X Pmt = $X Pmt = $X
|-----------------------------|--------------------|--------------------|-------------------|
1/1/2014 6/30/2014 12/31/2015 6/30/2015 12/31/2015
$22,038 = $X × [1 / (1.06)1 + 1 / (1.06)2 + 1 / (1.06)3 + 1 / (1.06)4]

$22,038 = $X × [0.943396 + 0.889996 + 0.839619 + 0.792094] = $X × 3.465105
Which gives us $22,038 / 3.4651 = $6,360
Note that THERE IS NO DIFFERENCE IN THE VALUE! All

three options are worth the same when compared in PV terms (or FV
terms): a single lump sum payment of $22,038 (i.e., the PV), four pay-
ments of $6,000 with the first paid today (i.e., annuity due), or four
payments of $6,360 with the first paid in 6 months (i.e., ordinary due).
However, the vendor may believe it is easier to sell the product if the four
lease payments are advertised as $6,000 instead of $6,360.7
Bond Valuation8
There are numerous types of bonds, but the most common is an ordinary
bond where the issuer agrees to make periodic payments plus a single
large payment at the end of the bond’s life. This single payment at the
end of the bond’s life is called the par or face value of the bond. The is-
suer also makes equal periodic payments (twice per year is the standard
in the United States and once is the standard in Europe) over the life of
the bond. These equal periodic payments are called the coupons and are
usually set as a fixed percentage (called the coupon rate) of the par or face
value of the bond.
7
A total of $22,038 also equates to a monthly annuity due payment of $1,024 vs.
a monthly ordinary annuity due payment of $1,034 with 24 monthly payments or
$722 and $729 with 36 monthly payments or $572 and $577 with 48 monthly pay-
ments, respectively, at an interest rate of 12.36 percent APY (or 11.7107 compounded
monthly).
8
A bond is a long-term debt obligation. Bonds are discussed in more depth in Chapter 9.
Let us illustrate with an example. A firm agrees to pay $1 million at

the end of 4 years (the face value) plus an additional $50,000 at the end
of each year for 4 years (the coupon).
$1,000,000 = Face value
$50,000 $50,000 $50,000 $50,000 = Coupon

|-----year 1-----|-----year 2----|------year 3------|-------year 4-------|
Issue End
The $1 million is the face value or par value of the bond. The $50,000
is the annual coupon, and it could be stated as a rate (called the coupon
rate or stated rate). In this case, the coupon rate would be 5 percent of the
par value (5% × $1,000,000 = $50,000). Knowing the coupon rate and
the face value gives you the coupon. Knowing the coupon and the face
value gives you the coupon rate.
What is the bond worth today, at the start of the bond’s life? This depends
on the market rate or yield of the bond. This is the interest rate the market
will pay given the terms of the bond, the economic conditions, and the
market’s assessment of the likelihood the firm will be able to make all
payments. It is the discount rate which equates the price of the bond in
the market and the bond’s payments. The market rate fluctuates over time
(in contrast to the coupon rate which is set in the terms of the bond). Let
us start by setting the market rate equal to the coupon rate of 5 percent.
The bond’s price is computed with a PV calculation:
PV = Pmt / (1 + r)1 + Pmt / (1 + r)2 + Pmt / (1 + r )3

+ Pmt / (1 + r )4 + Par Value / (1 + r )4
PV = $50,000 / 1.05 + $50,000 / 1.052 + $50,000 / 1.053

+ $50,000 / 1.054 + $1 million / 1.054
PV = $1 million
In this case, the bond is issued at par, which means the bond’s issue
price (e.g., the price at the time the bond is first issued) equals its par value.
Whenever the bond is at par, the market rate and the coupon rate are the
same. Conversely, whenever a bond’s coupon rate equals the market rate,
the price of the bond is the par value. Note that the coupon rate deter-
mines the amount of the coupon (in this case, 5% a year × $1 million
par value = $50,000 a year). Once set, the coupon does not change (it is
a contractual amount).9
Now, what happens if the market rate falls?10 The price (what someone
else would pay you for the bond) of the bond will increase. This occurs
because the denominator in the discounting formula above is the market
rate. If you hold a numerator constant and lower a denominator, the result
increases. Take the extreme case: Imagine that the market interest rate falls
to a rate of zero 2 years after the bond is issued. What is the value of the bond?
$1,000,000
paid paid $50,000 $50,000
|-----year 1-----|-------year 2------|------year 3------|------year 4------|
Issue Price here End
PV = Pmt / (1 + r)1 + Pmt / (1 + r)2 + Par value / (1 + r)2
At the start of the third year, the bond has three payments remaining: two
interest payments of $50,000 each as well as the final par value payment of
$1 million. In other words, by the end of the bond’s life, it will pay $1.1 mil-
lion. At a 5 percent market rate, the bond would have a price of $1.0 million.
50,000 / 1.05 + $50,000 / 1.052 + $1 million / 1.052 = $1.0 million
At a 0 percent market rate, the bond has a price of $1.1 million

50,000 / 1.00 + $50,000 / 1.002 + $1 million / 1.002 = $1.1 million
The calculation at a 0 percent market rate is always very easy, you
simply add up all the future cash payments, no discounting is required as
the denominator is always 1. Think about this:
Market rate (%) Bond price
0 $1.1 million
5 $1.0 million
Look at the above and then answer the following:
If the market rate is 7 percent (which means above the 5 percent coupon
rate), will the price of the bond be more or less than $1 million? If the market
9
There are some bonds where the coupon rate is based on a market rate (e.g., prime
plus 2 percent), but these are more complex bonds and their pricing would be much
more difficult.
10
This could happen either because the government rate falls or because the firm’s cash
flows to repay the debt become less risky.
rate is 3 percent (above 0 percent but below 5 percent), will the price of the
bond be more or less than $1 million? More or less than $1.1 million? Write
down your answer.
We have a simple way to understand what happens to bond prices as
market rates rise and fall. The approach also helps us check any calcula-
tions to ensure they are not seriously wrong. The maximum price of the
bond, which occurs at a 0 percent rate (extreme even for safe government
bonds), is $1.1 million. As shown above, at a 0 percent rate, the price of
the bond is the sum of all future payments (in this case, the two coupons
of $50,000 each and the par value of $1 million). The price of the bond at
par, when the market rate equals the coupon rate, is $1 million.
If the market rate rises above the coupon rate, the price of the bond
falls below the par value. If the market rate falls below the coupon rate,
the price of the bond will increase above par but will remain below the
maximum price from using a zero coupon rate.
Why does the price of a bond decrease when market rates increase, and in-
crease when market rates decrease? Because the numerator is the bond’s cou-
pons and par value that are set by the bond contract and do not change,
whereas the market rate that can change is in the denominator.
PV = Pmt / (1 + r)1 + Pmt / (1 + r)2 + . . . + Pmt / (1 + r)n + Par Value / (1 + r)n
This can be seen using the par value and coupon rate of our example:1112
Face value Coupon rate Market rate Bond value start of year 3
$1million 5% 0% $1.100 million
$1 million 5% 3% $1.038 million11
$1 million 5% 5% $1.000 million
$1 million 5% 7% $0.964 million12
The above can also be understood with the following example. Imag-
ine our firm issues a second $1 million face value bond at the start of
year 3. This bond will have a 2-year life, so it matures on the exact same
date as the first bond, which has a 4-year life and is halfway done. The
second bond pays interest once a year on December 31, so it has two
more coupon payments. If this second bond has its coupon rate set at
the market rate, and the market rate is 7 percent at the time, this bond
11
50,000 / 1.03 + $50,000 / 1.032 + $1 million / 1.032 = $1.038 million.
12
50,000 / 1.07 + $50,000 / 1.072 + $1 million / 1.072 = $0.964 million.
will be issued at par of $1 million (70,000 / 1.07 + $70,000 / 1.072 +

$1 million / 1.072 = $1.0 million).
Although the issue price of the second bond is the same as the issue
price of the first bond in year 1 (i.e., $1 million), the second bond now
pays an annual payment of $70,000 (7 percent of par) compared to the
first bond, which pays only $50,000 (5 percent of par).
Original Bond:
$1,000,000
paid paid $50,000 $50,000
|-----year 1-----|-----year 2-----|-----year 3-----|------year 4------|
Issue Now End
New Issue:
$1,000,000
$70,000 $70,000
|-----year 1-----|-----year 2-----|-----year 3-----|------year 4------|
Issue Now End
Which bond has a higher net present value (NPV) (which bond would
you rather own): The one paying $50,000 a year for the next 2 years plus $1
million at the end, or the one paying $70,000 a year for the next 2 years plus
$1 million at the end? The latter is worth $1 million ($70,000 / 1.07 +
$1,070,000 / 1.072). The first bond is worth less: As computed above, it
is worth $964,000 ($50,000 / 1.07 + $1,050,000 / 1.072).
Note, the $36,000 difference in the PVs ($1,000,000 − $964,000)
can also be calculated by discounting the $20,000 difference ($70,000 −
$50,000) in the PV of the two coupon payments at 7 percent.
$36,000 = $20,000 / 1.07 + $20,000 / 1.072
As market interest rates increase (decrease), the value of outstanding

bonds will fall (rise) because their future cash flows are worth less (more).
The Bottom Line

The time value of money is one of the most important concepts in fi-
nance. Your author strongly recommends always drawing a time line to
ensure the dates and amounts are correct.
The next chapter discusses the accounting for long-term liabilities
which use time values.
CHAPTER 9
Long-Term Debt
Long-term debt includes any financial obligations lasting more than 1

year. The two most common items are bonds, which are covered in this
chapter, and leases, which are covered in Accounting for Fun and Profit:
Understanding Advanced Topics in Accounting.
A bond represents a contract between two parties: the borrower (is-
suer) and the lender (purchaser). This chapter takes the perspective of the
firm issuing the bond (i.e., borrowing the money), which makes the bond
a liability on the Balance Sheet (increase cash and debt). A mirror image
of the discussion applies if the firm purchases another firm’s bonds (and
the bond would be an asset).
Corporate bonds are typically payable over long periods of time, nor-
mally ranging from 3 to 30 years.1 There have also been bonds with much
longer lives. In 1993, the Walt Disney Company issued $300 million of
bonds with 100-year lives (the firm had the right to buy back the bonds
after 30 years). Wall Street promptly called them “Sleeping Beauty Bonds.”2
The terms of a bond, the amounts to be paid and the payment dates
as well as any special features, are stated in a legal document called the
1
US government bonds have durations from 90 days (for a U.S. Treasury bill), to
10 years (for a U.S. Treasury note), to 30 years (for a U.S. Treasury bond).
2
Other organizations issuing 100-year bonds such as Coca-Cola, Federal Express,
Ford Motor, and several universities, including Tufts University and MIT. There have
also been 1,000-year bonds issued, and the UK government issued bonds with no
maturity date called Consuls, which basically make interest payments forever (and
are thus called perpetuals). Almost anything can be included into a bond contract.
For example, the All England Tennis Club, where the Grand Slam Wimbledon
tennis matches are played, has issued bonds which give the bondholders tickets to
Wimbledon tennis matches.
bond indenture. The key to understanding bonds is to understand all the

terms related to them as well as the concept of the time value of money
discussed in Chapter 8.
Face value, par value, or maturity value. All three terms mean the
same thing. This is the final payment at the end of a bond’s life, which
means when the bond obligation is terminated.
The coupon rate, contract rate, or stated rate. All three terms mean
the same thing. This is the interest paid as calculated by taking a percent-
age of the bond’s face value each year. The coupon is the actual interest
payment.3 In the United States, interest on bonds is normally paid twice
a year, whereas in Europe, interest on bonds is normally paid once a year
(so in the United States, the actual coupon payment is one-half of the
coupon rate, because coupon rates are listed in the terms as an annual
rate). The actual payment, the amount and when it is paid, is contractu-
ally stated in the terms of the bond.
The price or market value. This is the value assigned to the bond
at the present time by investors. It represents the present value (PV)
of all future payments in the bond contract, discounted at what in-
vestors (the market) consider the appropriate discount rate (different
from the coupon rate explained above). If the bond is issued at its face
value (which is often the case today), the bond is said to be sold at par.
If the bond is issued at a price above face value, the bond is said to
be sold at a premium. If the bond is issued at a price less than its face
value, it is said to be sold at a discount. Bond valuation is discussed
in Chapter 8.
The yield (to maturity), effective rate, or market rate. All three terms
mean the same thing. This is the discount rate mentioned above, which
3
Many years ago, bonds had detachable coupons: Parts of the bond would be liter-
ally cut from the actual hard copy of the bond, with an amount and a date written
on it. The coupon would be submitted to the issuing firm on or after the date on
the coupon, and the firm would then pay the amount of the coupon. Modern
bonds no longer have coupons that literally detach and funds are nowadays nor-
mally transferred electronically to the registered owner of the bond; however, the
term “detachable coupon” or “coupon” remains to describe the periodic interest
payments.
Long-Term Debt 129
equates the price of the bond with all future payments (coupons and face
value). Note that the coupon rate (or coupon) does not change over the
life of the bond: It is a contractual rate set in the bond indenture. By con-
trast, the discount rate (i.e., yield, effective rate, or market rate) changes
because of changes in the economy (e.g., as government interest rates rise
or fall, so will the firm’s discount rate) as well as changes in the market’s
perception of the firm’s risk level (e.g., the likelihood that all of the pay-
ments related to the bond will be made). As the discount rate changes, so
will the price of the bond (as explained in the bond valuation section in
Chapter 8).
Covenants are restrictions placed on the issuer/borrower that, if vi-
olated, allow the bondholder to demand immediate repayment of the
bond. They can be set as actions the borrower is not allowed to undertake
(e.g., paying dividends above a certain amount of earnings, limiting ad-
ditional debt, prohibiting senior debt), actions the borrower must take
(e.g., providing annual audited statements to the bondholders or their
agent), or creating some prescribed standard the borrower must meet
(e.g., maintaining a set ratio such as current assets to current liabilities of
1.5 or more).4
Security or collateral represents specific assets pledged to the bonds
if the company cannot repay its obligation.5 That is, if a firm does not
meet any of the terms of the bond (e.g., fails to make a coupon pay-
ment or violates a covenant), the bondholder can demand immediate
payment of the bond’s face value. If the firm is unable to pay (which
is likely if the firm missed a coupon payment), the bondholder can
take possession of the security and sell it to obtain repayment. If the
funds from the sale are greater than the amount owed, the balance is
4
Almost anything can be written into the bond contract. For example, bonds may
contain a provision saying that the bondholder can demand repayment if there is a
hostile, or any, takeover of the firm. If a bond has few or no covenants it is referred to
as “covenant light.”
5
The security or collateral does not have to be a physical asset. In 1997, the singer
David Bowie issued $55 million of 10-year bonds where the collateral was the
royalties from certain songs of his. The bonds were dubbed Bowie Bonds by Wall
Street.
returned to the firm. If the funds from the sale are less than the amount
owed, the bondholder has an unsecured claim (along with all other
unsecured claimants) on all of the firm’s other assets. Note that bonds
can be secured or unsecured. Bonds that are unsecured are also called
debentures.6
Priority of claims or payments. Whether secured or unsecured,
bonds can specify a priority of payment in the event of liquidation or
bankruptcy. Senior debt (first priority) is paid before junior debt (sec-
ond priority). Priority exists by default between secured and unsecured
bonds, because secured bonds have collateral that is handed over to
bondholders. But priority can be explicitly laid out within secured and
unsecured bonds as well (e.g., senior and junior secured, senior and
junior unsecured).
Redeemable bonds contain a feature that provides the bondholder the
option to exchange the bond for a preset value (often at a slight discount
to the face value) prior to the final maturity of the bond. A single bond
can have multiple dates at which bondholders are able to exchange their
bonds and can have different values for each date. However, most bonds
are nonredeemable.
Callable bonds contain a feature that provides the issuer the option to
pay off the debt at a preset price (often at a slight premium over the face
value) prior to the final maturity of the bond. As noted above, Disney’s
100-year “Sleeping Beauty” bonds have a 30-year call feature. Disney re-
served the right to buy back the bonds (i.e., force the bondholders to sell
them back to Disney) after 30 years.
Convertible bonds contain a feature that allows the bondholder to
exchange the bond into shares of the firm’s equity at a set rate(s) on a
specific date(s). For example, let us say a bond with a face value of $1,000
is exchangeable into 50 shares of common stock on July 1, 2018. Let
6
Although the term debenture means an unsecured bond, whether the bond actu-
ally has security or not depends on the indenture. Your author has seen “secured
debentures,” which indicates the lawyer drafting the indenture wanted to use a more
grandiose term than bond and apparently did not know that the word debenture
means unsecured bond.
Long-Term Debt 131
us also say the market price of the 50 shares on July 1, 2018, is above
the price of the bond (remember, the price of the bond is the PV of the
future coupon payments and face value). The bondholder has an incen-
tive to swap his convertible bond for the shares. There are numerous
variants of this theme (i.e., the bonds can have a call feature where the
firm can force the bondholders to convert to equity at a specific date).
The conversion features allow the bondholder to gain if the firm’s stock
price rises dramatically. In return for this option, the bond has a lower
coupon rate. This can be attractive for high-risk firms, as they would
otherwise have to offer high coupon rates. The majority of bonds issued
are nonconvertible.
Bond Ratings
There are companies that provide their opinions on the likelihood
that a firm’s debt will be repaid. These opinions are given in the form
of a rating or score. In the United States, there are three major firms
that do this. Standard and Poor’s (S&P) and Moody’s dominate the
market, followed by Fitch Ratings (Fitch). Each firm has a slightly dif-
ferent rating system. For example, S&P (and Fitch) has its best rating
as AAA followed by AA+, AA, AA−, A+, and so on. By contrast,
Moody’s top rating is Aaa, followed by Aa1, Aa2, Aa3, A1, and so
on. Exhibit 9.1 provides a description of various ratings for S&P. It is
important to note that the issuing firm pays the rating agencies, which
only issue an opinion (like the audit report) but, by government fiat,
cannot be sued for issuing incorrect or misleading opinions (unlike
the auditors). As such, and because rating agencies have proven un-
reliable in the past, your author suggests they are of dubious value
to investors.7 The ratings become important because various financial
institutions (e.g., banks, insurance companies, and pension plans) are
required by law to hold only securities rated BBB (called “investment
7
Prior to the financial crisis of 2009, these agencies were rating numerous securities
as AAA, which proved to be next to worthless (in fact, at the time, even without
hindsight, any reasonable examination should have led to ratings well below BBB).
Exhibit 9.1
Example of S&P long-term credit ratings
AAA Extremely strong capacity to meet
financial obligations
AA Very strong ... differs from AAA only by a small degree
A Strong ... more susceptible to adverse effects of changes
BBB Adequate capacity (BBB and above are called “investment
grade”). Below BBB are regarded as having significant
speculative characteristics
BB Less vulnerable in the near term than those below
B Current capacity to meet obligations but more
vulnerable
CCC Currently vulnerable
CC Highly vulnerable
C Currently highly vulnerable (bankruptcy may have been
filed)
R Under regulatory supervision
SD Selective default, likely to continue paying some debt
D Default
NR Not rated
grade”) and above. Thus, the government has created a market for
these ratings.
Accounting for Bonds

The accounting for bonds at the time of issue is straightforward.
(Remember that we are looking at bonds from the issuer’s perspective.)
The issuing firm receives cash and has a long-term liability (increase cash
and debt). Over time, the firm records interest expense at the time of
payment (and if payment is not at year-end then, at year-end, an adjust-
ment is made for the partial period from the last payment to year-end).
If the bond is paid off at the end of its life, the final payment reduces the
debt to zero. If the bond is paid off prior to its maturity date, then a gain
or loss is recorded if the payment is more (loss) or less (gain) than the
outstanding debt.
Long-Term Debt 133
To illustrate, assume a 3-year bond with a 6 percent semiannual cou-

pon is issued at par on January 1, 2015. The accounting entries for the
bond would be as follows:
Bond Retained Interest

Spreadsheet Cash payable earnings expense
01/01/2015 ($ 1,000,000) $ 1,000,000
06/30/2015 ($ 30,000) $ 30,000
12/31/2015 ($ 30,000) $ 30,000
12/31/2015 ($60,000) ($ 60,000)
06/30/2016 ($ 30,000) $ 30,000
12/31/2016 ($ 30,000) $ 30,000
12/31/2016 ($60,000) ($ 60,000)
06/30/2017 ($ 30,000) $ 30,000
12/31/2017 ($ 30,000) $ 30,000
12/31/2017 ($ 1,000,000) ($1,000,000)
12/31/2017 ($60,000) ($ 60,000)
Using entries:
1/1/2015 Cash $1 million

Bond payable $1 million
6/30/2015 Interest expense $30,000
Cash $30,000
Cash $30,000
12/31/2015 Retained earnings $60,000
Interest expense $60,000
The last three entries are repeated in 2016 and 2017, with one final
entry at the end of the bond’s 3-year life:
12/31/2017 Bond payable $1 million

Cash $1 million
What if the bond is repurchased prior to its maturity date at a value dif-
ferent from its accounting (book) value? There will be a gain or loss on the
repurchase. For example: What is the accounting entry if the bond was
purchased on January 1, 2017, for $1,009,637?8 It is:
1/1/2017 Bond payable $1,000,000
Loss on repurchase of bond $ 9,637
Cash $1,009,637
The bond payable is reduced to zero, cash is reduced by the amount

the issuer paid to repurchase the bond, and there is a loss on the repur-
chase because the price paid is above the bond’s accounting value. Had
the bond been purchased for $990,502,9 the firm would have recorded
a gain of $9,498. Note that the gain or loss is determined by the differ-
ence in the market value of the bond and the bond’s accounting value
at the time: The price the issuer paid to repurchase the bond minus
value of bond on the books equals the gain or loss to be recorded.
Finally, to illustrate a bond payment made on a date other than
year-end, assume the above bond was issued on February 1, 2015, with
interest payments on July 31 and January 31 and a final maturity on Janu-
ary 31, 2018. The entries would be as follows:
Interest Bond Retained Interest
Date Cash payable payable earnings expense
02/01/2015 $1,000,000 $1,000,000
07/31/2015 ($ 30,000) $ 30,000
12/31/2015 $25,000 $ 25,000
12/31/2015 ($55,000) ($ 55,000)
01/31/2016 ($ 30,000) ($25,000) $ 5,000
07/31/2016 ($ 30,000) $ 30,000
12/31/2016 ($25,000) $ 25,000
12/31/2016 ($60,000) ($ 60,000)
01/31/2017 ($ 30,000) ($25,000) $ 5,000
07/31/2017 ($ 30,000) $ 30,000
12/31/2017 $25,000 $ 25,000
12/31/2017 ($60,000) ($60,000)
01/31/2018 ($ 30,000) ($25,000) $ 5,000
01/31/2018 ($1,000,000) ($1,000,000)
12/31/2018 ($ 5,000) ($ 5,000)
8
As explained in Chapter 8, this would be the bond price if the yield fell to 5 percent
compounded semiannually ($30,000 / 1.025 + $1,030,000 / 1.0252).
9
This would be the bond price if the yield increased to 7 percent compounded semian-
nually ($30,000 / 1.035 + $1,030,000 / 1.0352).
Long-Term Debt 135
As can be seen, when financial statements are prepared at the end of

the year, $25,000 in interest is accrued for the 5 months from the prior
payment on July 1. Then, when the $30,000 coupon payment is made
on January 31, the payment amount reduces the $25,000 liability from
the prior year and $5,000 of interest for the 1 month is recorded. For the
payment on July 1, the full amount is recorded as a decrease in cash and
an increase in interest expense. Then at year-end, the $25,000 accrual is
made again.
Other Types of Bonds

The above description is for a regular, or ordinary, type of bond that has
periodic interest payments and a lump sum payment at the end of its life.
However, there are numerous other types of bonds (indeed almost any
payment stream can be written into the indenture).
Let us consider a much simpler bond: a zero-coupon bond. This is
a bond that makes no periodic interest payments (it has a coupon with
a zero interest rate). All of the compounded interest is reflected in the
final payment. Thus, the bond’s price must be lower than its face value
(the final payment) because the final payment includes all of the interest
earned. Staying close to our example above, assume a 3-year bond is-
sued for $1 million on January 1, 2015, yielding 6 percent compounded
semiannually but making no payments until it matures on December 31,
2017, for $1,194,052.10
Despite no cash being paid, the interest expense is still recorded
and the bond payable increases over time until it is repaid in one lump
sum. Also, note that retained earnings are changing at the end of the
calendar year (December 31 of 2015 and 2016) because the firm closes
its books and prepares its Income Statement at the end of each calen-
dar year.
10
As explained in Chapter 8, this is simply $1 million × 1.036 = $1,194,052. Also,
note that coupon payments do not compound (do not pay interest on interest).
The coupon is a payment that would have to be reinvested. By contrast, the inter-
est on a zero-coupon bond does compound as it is not paid until the end of the
bond’s life.
The accounting entries would be as follows:

Date Cash payable earnings expense
01/01/2015 $1,000,000 $1,000,000
06/30/2015 $ 30,000 $ 30,000
12/31/2015 $ 30,900 $ 30,900
12/31/2015 ($ 60,900) ($ 60,900)
06/30/2016 $ 31,827 $ 31,827
12/31/2016 $ 32,782 $ 32,782
12/31/2016 ($ 64,609) ($ 64,609)
06/30/2017 $ 33,765 $ 33,765
12/31/2017 $ 34,778 $ 34,778
12/31/2017 ($1,194,052) ($1,194,052)
12/31/2017 ($ 68,543) ($ 68,543)
A serial bond, or mortgage bond (or mortgage), is normally given

with real estate as collateral and often has only periodic payments with
no final lump sum (i.e., it is basically an annuity, which was described in
Chapter 8). Staying close to our example above, assume a 3-year bond
making payments twice a year (on June 30 and December 31) is issued
for $1 million on January 1, 2015, yielding 6 percent compounded (paid)
semiannually. What are the periodic interest payments? They are $184,598.11
The accounting for the bond would be as follows:

Date Cash payable earnings expense
01/01/2015 $1,000,000 $1,000,000
06/30/2015 ($ 184,598) ($ 154,598) $30,000
12/31/2015 ($ 184,598) ($ 159,236) $25,362
12/31/2015 ($55,362) ($55,362)
06/30/2016 ($ 184,598) ($ 164,013) $20,585
12/31/2016 ($ 184,598) ($ 168,933) $15,665
12/31/2016 ($36,250) ($36,250)
06/30/2017 ($ 184,598) ($ 174,001) $10,597
12/31/2017 ($ 184,598) ($ 179,219) $ 5,379
12/31/2017 ($15,976) ($15,976)
As explained in Chapter 8, it would be $1,000,000 / (1/1.03 + 1/1.032 + . . . +1/1.036).

11
Long-Term Debt 137
As shown in the amortization table that follows, each cash payment

of $184,598 is part interest and part bond repayment. The interest por-
tion is reduced over time from $30,000 ($1 million × 3%) to $5,377
($179,218 × 3%) because the balance owed is declining. As the interest
portion falls, the bond repayment portion (a decrease in debt, or accumu-
lated bond repayment) increases from $154,598 ($184,598 − $30,000)
to $179,219 ($184,598 − $5,379) because the amount that has been
cumulatively paid increases with each payment.
Amortization table:
Debt start Interest Subtotal Payment Debt down
$1,000,000 $30,000 $1,030,000 $184,598 $154,598
$ 845,402 $25,362 $ 870,764 $184,598 $159,236
$ 686,166 $20,585 $ 706,751 $184,598 $164,013
$ 522,153 $15,665 $ 537,818 $184,598 $168,933
$ 353,220 $10,597 $ 363,816 $184,598 $174,001
$ 179,219 $ 5,379 $ 184,595 $184,598 $179,219
Let us compare across the three different types of bonds. In the regular
bond example, the interest expense stayed the same over time because
the amount of debt borrowed stayed constant (as the interest was always
being fully paid). In the zero-coupon bond example, the interest expense
increased over time as the debt increased with the compounded interest.
In the mortgage bond example, the interest expense falls over time because
the debt is being reduced (at increasing amounts) with each payment.
Differences in interest expense across the three types of bonds:12
Ordinary Zero coupon Mortgage

Year 1 $60,000 $60,900 $55,362
Year 2 $60,000 $64,609 $36,250
Year 3 $60,000 $68,543 $15,976
12
Remember, the interest expense and the payment do not have to be the same.
Premiums and Discounts

If, at the date of issue, the market rate (or yield) on a bond is less than its
coupon rate, then the bond will be issued at a price above par value (called
a premium). If, at the date of issue, the market rate (or yield) on a bond
is more than its coupon rate, then the bond will be issued at a price below
par value (called a discount).
To illustrate, assume a 3-year bond with a face value of $1 million
and a 6 percent semiannual coupon (or $30,000 every 6 months) is is-
sued on January 1, 2015, with a yield of 5 percent compounded semian-
nually.13 Because the coupon of 3 percent (6 percent semiannual coupon
divided by two) is more than the yield of 2.5 percent (the 5% / 2), the
bond will be sold at a price above its face value (more than $1 million).
Remember that the bond’s price equals the PV of all the coupon and face
value payments. This means the price can be computed like any other PV
computation:
Net present value (NPV) = $30,000 × (1/1.025 + 1/1.0252 + 1/1.0253

+ 1/1.0254 +1/1.0254 + 1/1.0255
+ 1/1.0256) + $1,000,000 × 1/1.0256
NPV = $1,027,541
Using a spreadsheet:
Time Payment PV factor Pmt / PV
1 $ 30,000 1.025 $ 29,268
2 $ 30,000 1.05063 $ 28,554
3 $ 30,000 1.07689 $ 27,858
4 $ 30,000 1.10381 $ 27,179
5 $ 30,000 1.13141 $ 26,516
6 $ 30,000 1.15969 $ 25,869
6 $1,000,000 1.15969 $ 862,297
Price = NPV $ 1,027,541
13
The 5 percent semiannual yield is on the issue date and will change over time.
Long-Term Debt 139
The accounting entry for the bond at the date of issue could be simply:
1/1/2015 Cash $1,027,541

Bond payable $1,027,541
$1 million face value bond, 6 percent semiannual coupon,
issued to yield 5 percent.
However, normally the accounting sets up the bond payable liability

at the face value, which means a separate account is set up for the pre-
mium or discount (the latter being a contra account similar to allowance
for doubtful accounts). Thus, the entry for the above example would be
as follows:
1/1/2015 Cash $1,027,541

Bond payable $1,000,000
Premium on bond $ 27,541
$1 million face value bond, 6 percent semiannual coupon,
issued to yield 5 percent.
Note that on the Balance Sheet, the liabilities would be the net bond
payable (the bond payable plus the premium or less the discount).
The discount or premium is then amortized (reduced to zero) over the
life of the bond. Many years ago, prior to personal computers, it was com-
mon to amortize using a “straight-line method” by dividing the discount
or premium by the number of payments (in this case, it would have been
the $27,541 premium divided by the six payments in the 3-year life of
the bond = $4,590). Interest expense would have been the cash payment
less the straight-line amortization amount in the case of a premium, or
the cash payment plus the straight-line amount in the case of a discount.
Thus, the periodic entry for each interest payment would have been as
follows:
Cash $30,000
The interest expense would have been calculated as $25,410

($30,000 − ($27,541 / 6)), and the amount would be the same each
time an interest payment (cash down) were made and prompted an inter-
est expense to be recorded.
Today the premium or discount must be amortized using what is
called the “effective rate method.” Here, the yield at the date of issue is
applied on the net Balance Sheet amount (which means bond payable less
the discount or plus the premium) to obtain the interest expense. Then
the difference between the interest expense and cash is the amortization
on the discount or premium. Following today’s practices, the first entry
in our example would be as follows:
6/30/2015 Interest expense $ 25,689

Cash $30,000
Interest expense = $ 1,027,541 × 2.5%
The interest expense will thus decrease over time with a premium
or increase over time with a discount. As the premium (discount) is
reduced to zero, the interest expense declines (increases) because the
rate times the face value plus (minus) the declining premium (declining
discount). The amortization table that follows shows how the amounts
change for the example:
Date Start +Interest −Cash End Date

1/1/2015 $1,027,541 $25,689 −$30,000 $1,023,229 6/30/2015
6/30/2015 1,023,229 25,581 −30,000 1,018,810 12/31/2015
12/31/2015 1,018,810 25,470 −30,000 1,014,280 6/30/2016
6/30/2016 1,014,280 25,357 −30,000 1,009,637 12/31/2016
12/31/2016 1,009,637 25,241 −30,000 1,004,878 6/30/2017
6/30/2017 1,004,878 25,122 −30,000 1,000,000 12/31/2017
Note that, in the example, the interest expense is always 2.5 percent
times the net amount owed. After the final payment, the discount or
premium on the bond has been reduced to zero. On the last day, the face
value ($1 million) is paid and the debt is removed.
Long-Term Debt 141
Disclosures
When long-term debt matures in the coming year, the amount is reclassi-
fied to current liabilities under the caption “current portion of long-term
debt.” However, normally the entire amount is still also shown as long
term, less the current portion, for a net amount.
Current liabilities:
Current portion of long-term debt B
Long-term liabilities:
Long-term debt A
Less current portion of long-term debt B
Net long-term debt A−B
The Bottom Line

This chapter covered the terminology and accounting for long-term debt.
The next chapter completes our walk down the Balance Sheet by looking
at owners’ equity.
CHAPTER 10
Owners’ Equity
Owners’ equity, funds given to the firm by its owners plus cumulated
earnings retained by the firm, is the final category in the Balance Sheet
equation:
Assets = Liabilities + Owners’ Equity
Like many prior chapters, the owners’ equity chapter has lots of termi-
nology. However, once you understand the terminology, the accounting
choices explained in this chapter will hopefully feel straightforward.
Contributed Capital
The nature of a firm’s ownership and control is set out in its corporate
charter (or articles of incorporation), which in the United States is gov-
erned by state law. Corporations can incorporate in any state whether
they have business operations in the state or not. Most U.S. public firms
(over half of all public firms and 64 percent of the Standard and Poor’s
[S&P] 500 firms1) are incorporated in the State of Delaware that has
a court system (the Delaware Chancery) largely dedicated to corporate
matters and is viewed by many as corporate-friendly (in the sense of anti-
takeover, antilawsuits, and so on).
The first set of accounts in owners’ equity is called contributed capital.
As previously noted, contributed capital is the cumulative amount all the
individual owners have given to the firm. However, the firm’s accountants
1
As of September 2014. See http://technically/delaware/2014/09/23/why-delaware-
incorporation/.
usually break down this amount to provide more detail related to differ-
ent ownership terms.
The accountants state what type, or class, of shares the owners have.
A firm may have different types of ownership units but a corporation
must have at least one residual voting class of common shares (stock) rep-
resenting the owners’ investment in the firm and subordinate to all others.
It can also have what are called preferred (or preference) shares and there
can be additional classes within each of these categories.
The amount the owners give a firm for a particular class of share (i.e.,
the price the owners pay per share) can be broken into two categories:
“par value” (a notional value attached to the shares) and “additional
paid-in capital in excess of par value” (the difference between the total
amount the owners paid and the par value).2 Shares can also be issued as
non-par value, which means there is just the one category. Although there
are some technical legal issues concerning par value shares, the distinc-
tion between par value and contributed capital (par value plus additional
paid-in capital in excess of par) generally has no impact on the vast num-
ber of public firms and the users of their financial statements. For this
reason, many users (your author included) often sum the par value and
additional amount for each class of shares and simply have one line called
contributed capital for each class of shares in their spreadsheet.
Also, remember the amounts recorded are what the owners give the
firm for shares (that is why the item is called “contributed capital”). When
the shares are subsequently traded between members of the public, the
prices paid on the market have no effect on the firm or its financial state-
ments because the capital is being exchanged between shareholders and
not between a shareholder and the firm.
There are three nonfinancial amounts associated with shares:
• Authorized, the legal maximum number issuable according to

the corporate charter.
• Issued, the number of shares the firm has given to owners.
2
The par value of shares is not analogous to the par value of bonds. Par value of shares
is, as noted, a fictional amount which bears no relationship to what the owners will
receive in the future.
Owners’ Equity 145
• Outstanding, the number of issued shares less any

repurchased.
One major distinction between types of shares is whether or not their

owners have voting power in the firm. Generally, the voting shares are
common shares. At least one class (category) of shares must be voting
At the end of 2015, the Ford Motor Company had roughly 3,960 mil-
lion shares of Class A common stock and 71 million shares of Class
B common stock. In fact, the Class B shares had 40 percent of the
total votes (or roughly 37 votes per Class B share) despite the fact
that the Class B shares numbered only 1.8 percent of the total com-
mon shares. According to Ford’s 2015 Annual Report (Note 23, page
FS-58), “Holders of our [Class A] Common Stock have 60 percent of
the general voting power and holders of our Class B [Common] Stock
are entitled to such number of votes per share as would give them the
remaining 40 percent. Shares of [Class A] Common Stock and Class
B [Common] Stock share equally in dividends when and as paid, with
stock dividends payable in shares of stock of the class held.”
Why did the Ford Motor Company give some common shares a different
number of votes per share than it gave other common shares? The voting
structure was designed to give the Ford family control of the firm. The
Class B common shares could only be owned by an heir of Henry Ford.
In fact, the details of Ford’s Class B common shares are even more fun.
It seems Henry wanted to provide an incentive for the family to keep
their shares in the family. The Class B common shares voting power
drops from 40 to 30 percent (from 37 votes per share to 24 votes per
share) if the family’s holding falls below 60.7 million shares. Further-
more, if the family holdings fall below 33.7 million shares, then the
shares become normal common shares with one share one vote. More-
over, if a family member sells a Class B common share to a nonfamily
member, it becomes a Class A common share and can never revert back.
See http://beginnersinvest.about.com/od/stocksoptionswarrants/a/ford-
dual-class-stock.htm
shares, but there can be multiple classes having one vote per share or
having different numbers of votes per share. For example, there could be
three (or more) classes of common shares: Class A, nonvoting; Class B,
one share one vote; and Class C, with multiple votes per share.3
Preferred shares have, as their name suggests, a preference over the
common shares.4 What kinds of preference do preferred shares have? First,
the preferred shares are entitled to receive a dividend before any can
be paid to the common shares.5 Second, the dividend on the preferred
shares is often at a set amount (e.g., $1.00 per share) and can be ei-
ther cumulative or noncumulative—these shares are called “cumulative
preferred shares” and “noncumulative preferred shares.” The cumula-
tive feature is extremely important to the value of preferred shares. The
cumulative feature means that if the preferred shares do not receive a
dividend in a particular year, the amount accumulates to the next. For
example, if a cumulative preferred share with a $1.00 stated dividend is
not paid a dividend for 6 years, then in the seventh year, the preferred
shareholders would have to receive $7.00 before any dividends can be
paid to the common shareholders ($6.00 from accumulated dividends
of prior years plus $1.00 for the current year). If the preferred shares are
noncumulative, in the seventh year preferred shareholders would only
have to receive $1.00 per share before a dividend can be paid to the
common shareholders. Third, the preferred shares can have a convertible
feature allowing the holder to turn them in for a set number of common
shares. Fourth, the preferred shares may have a call feature, allowing
the firm to buy them back at a set price. Finally, they can be voting or
nonvoting.
3
There is even an idea to have “tenured” shares where the shares have more votes based
on the years they have been owned (one vote if owned less than a year, two votes if
owned for 2 years, and so on). See D.K. Berman. March 18, 2015. “Seeking a Cure
for Corporate Activism,” The Wall Street Journal, B1.
4
Note that in the United States, the words “shares” and “stock” are used interchange-
ably. In the UK, the word “stock” normally means inventory.
5
Remember, a firm does not have to pay a dividend. The dividends only become a
required payment if the board of directors declares them. Of course, the shareholders
have the power to vote in board members and thus, indirectly, generate the dividends
(e.g., by voting in people they believe will tend to have the firm pay dividends).
Typical ownership share classifications

Type of shares Features
Preferred shares Cumulative or noncumulative
Participating or nonparticipating
Convertible (to common) or nonconvertible
Callable or noncallable
Voting or nonvoting
Common shares Voting or nonvoting
Retained Earnings
As noted back in Chapter 3, retained earnings are the cumulative profit
or loss a firm has made from its inception to the date of the Balance Sheet
less any funds given to the owners, which are called dividends. Retained
earnings can be written as:
Opening R/E + Profit − Loss − Dividends = Ending R/E
Profit and loss, as previously noted, are the closing (resetting to zero)
of the temporary revenue and expense accounts. Thus, the only new vari-
able here is dividends, which are the distribution of accumulated profits
to the owners.
Firms with excess cash (funds they do not need to maintain or grow
their business, acquire new businesses or pay down their debt) can return
these funds to the owners by paying dividends.
There are three important dates related to dividends:
• Declaration—the date the board of directors declares that the

firm will pay dividends (the declaration makes the firm legally
bound to pay the dividends it declared).
• Record—the date determining which owners get the dividend
(the holder on the record date gets the dividend).6
6
Another discussed date is the “ex-dividend date.” This is usually two business days
before the record date. The seller of a stock on the ex-dividend date (rather than the
buyer) will receive the dividend.
• Payment—the date the dividend will be paid (to the

shareholders of record).
The timing of these events must occur in this order (declaration, record,
and payment). However, the events can be on the same date, or two dates,
or three dates.
It is important to note that dividends can only be paid up to the
amount of retained earnings (dividends cannot be paid when retained
earnings are negative or in an amount that would cause retained earnings
to become negative). If the firm has no retained earnings (or has a deficit
with accumulated losses exceeding accumulated profits), it cannot legally
pay a dividend, and if it does, the directors become personally liable to
the firm’s creditors for the difference. However, it is possible for a firm to
pay a dividend when it has positive retained earnings but subsequently
lose money, causing retained earnings to become a deficit. It should also
be noted that dividend payments are “sticky.” Once a firm starts paying a
dividend, it is usually very reluctant to stop paying the dividend or even
decrease it because doing so normally causes a sharp decline in stock price.
Treasury Stock
Dividends are not the only method a firm has to provide funds to its own-
ers. An alternative method is for the firm to repurchase its own shares.
Share repurchases usually have lower tax rates for shareholders. So why
don’t firms use share repurchases instead of dividends? Primarily because the
International Revenue Service (IRS) will treat repurchases as dividends if
a firm does regular repurchases (e.g., every quarter). Share repurchases are
often done: (1) as part of a merger involving a stock swap, (2) to fend off a
hostile takeover, (3) to redeem stock options in share-based compensation
plans, or (4) to increase or stabilize earnings per share (the latter two are
discussed in more detail in Accounting for Fun and Profit: Understanding
Advanced Topics in Accounting).
There are three main ways firms repurchase their shares. One is open
market purchases, simply buying shares in the market like anyone else.
A second is called a fixed price tender. Here the firm publicly announces
details of the number of shares it hopes to buy and the set (fixed) price it
will pay. The firm is then obligated to buy at least the minimum number
to which it committed, but it can buy more. Finally, firms can also repur-
chase their shares using what is called a “Dutch auction tender.” Here the
firm sets the number of shares but not the price per share, or the firm sets
the price per share but not the number of shares it will purchase.7
Regardless of how a firm repurchases its shares, there is NEVER a gain
or loss on the repurchase of a firm’s own shares. This differs from a firm’s ac-
counting of marketable securities, where the firm reports a gain or loss on its
investment. When buying back its own shares, the firm records a decrease in
cash and a decrease in either contributed capital (if the firm retires the shares)
or an increase in account called “treasury stock”—in either case, owners’ eq-
uity is reduced. (Treasury stock is a contra or negative equity account that
reduces owners’ equity. If treasury stock increases, it means that the firm has
decided not to retire the shares and can reissue them in the future.)
If at some future point, the firm decides to issue additional shares,
and it has both unissued shares (authorized shares that have never been
issued) and treasury stock (once issued shares that were repurchased), it
can issue either. Basically, cash increases and either contributed capital
increases or treasury stock decreases. There are some additional details
on how this is done, but it generally does not impact the outside user of
financial statements.
Stock Dividends and Stock Splits

Firms sometimes provide owners (shareholders) with additional shares
instead of cash dividends. This is known as a “stock dividend” and has two
impacts. First, the number of shares issued and outstanding is increased.
Second, contributed capital increases and retained earnings decreases by
the number of shares times the market price (if there is no market price,
some estimate is used). Remember, owners’ equity is comprised of con-
tributed capital and retained earnings. A stock dividend is simply a real-
location of the components of owners’ equity.
7
Most, but not all, countries allow firms to repurchase their own shares. Additional
details on why and how a firm repurchases its own shares are beyond the scope of this
book but available in most finance textbooks.
Although a stock dividend has no impact on total owners’ equity, it

does have an impact on dividends. Remember, as noted above, firms are
only allowed to pay dividends up to the amount in retained earnings. By
paying a stock dividend, the firm increases its contributed capital and
reduces its retained earnings, thereby reducing its future dividend-paying
ability.
Firms can also decide to split their stocks. This changes the number
of shares authorized, issued, and outstanding, but it has no impact on
any dollar amounts in the accounts. So, why would a firm do a stock split?
The reason is to change the market price of the shares. For example, con-
sider the price of one Class A share of Berkshire Hathaway. On April 7,
2016, the shares traded at $211,000 per share. Someone with $50,000 to
invest could not buy a share. Additionally, someone with one share who
wanted $30,000 to buy a car could not sell part of a share in order to get
the money he or she needed. In the past, Warren Buffet, the legendary
investor behind Berkshire Hathaway, did not want lots of small investors
and was happy having shares that not everyone could afford (he also has
never paid a dividend). Then, in 1996, he changed his mind and decided
to bring his shares to the masses by creating a second class of shares. Why
did Warren Buffet change strategies and decide to welcome small investors?
His stated reason was to stop brokerage houses from trying to attract
business by buying his shares and offering fractional ownership to their
clients. Now, a Class B share of Berkshire Hathaway is worth 1/1,500th
of a Class A share. The Class A shares can be converted into 1,500 Class
B shares. The Class B shares cannot be converted to Class A shares. Only
the Class A shares have the right to vote (one vote per share). The Class B
shares traded on April 7, 2016, at $140.51. Note the Class A shares have
a vote, so the Class B shares should be worth less, which while not always
true, was true on April 7, 2016 (1,500 Class B shares were trading for
$210,765 ($140.51 each) vs. the $211,000 for a Class A share).
Most public firms try to keep their shares under $100 per share. For
example, Apple Inc. initially issued its shares for $22 a share back on
December 12, 1980. The firm then split its shares two for one on three
separate occasions (June 15, 1987; June 21, 2000; and February 28, 2005)
and most recently, split the shares seven for one (on June 9, 2014). When
Apple announced the most recent split on April 23, 2014, its shares were
trading at $524.75. The seven-for-one split would value each share at

$74.96. At the time, the average share in the S&P 500 was $77.91.8
This means that one original Apple share purchased for $22 in 1980
would have morphed into 57 shares today. Apple shares traded at a value
of $116.47 on November 21, 2014, which means an initial $22 in-
vestment would have increased to $6,638.79 (57 shares times $116.47
each).9 This is a total increase of 30,000% (or an average annual return
of 26.9%). Someone who invested $3,322 in Apple in 1980 (purchased
151 shares for $22 each) would now have 8,607 shares worth just over $1
million (8,607 × $116.47).
Firms can also do reverse splits. This is done when a firm’s share price
is falling. Many stock exchanges (NYSE, NASDQ, and so on) have rules
preventing the trading of shares if they fall below a certain price (e.g.,
$1.00 per share). A reverse split will normally increase a share’s market
price, but often at less than the presplit value (e.g., a share trading at
$1.50 has a one-for-three reverse split and the price moves to $4.00 not
$4.50). This is because a reverse split is seen as a negative signal: It tells
the market that management is worried that the shares will fall below the
exchange minimum.
The Bottom Line

Owners’ equity represents the funds given to the firm by the owners, the
cumulative profits and losses earned by the firm, less amounts returned
by the firm to the owners.
This ends our, Chapters 5 through Chapter 10, walk down the Bal-
ance Sheet. The next chapter presents a discussion of cash flows.
8
See http://blogs.wsj.com/moneybeat/2014/04/23/apples-7-for-1-stock-split-is-very-
unusual/ (viewed November 23, 2015).
9
Alternatively, adjusting for the splits, each of the 57 shares cost only $0.39 ($22 / 57).
CHAPTER 11
Cash Is King
So far in the book we have been discussing financial statements pre-

pared using accrual accounting, which recognizes revenues when they are
earned and then tries to match the related costs to the revenues. Where
the costs cannot be matched, they are included in the period in which the
costs are incurred. Unfortunately, matching costs and revenues requires
numerous estimates and assumptions and is subject to much debate and
interpretation.
There is another, simpler, way to prepare accounting statements. All
transactions can be measured in terms of cash flows into a corporation
and cash flows out of a corporation. Imagine a firm has only one asset:
cash. Revenues occur when cash increases, and expenses occur when
cash decreases. Cash is simple, direct, and clear. It can be measured
directly and is not subject to the estimates and assumptions of other
accounts.1 Cash is straightforward to measure because a firm either has
it or does not.
Furthermore, finance values investments based on future cash flows.
Financial statements provide the starting point to estimate those future
cash flows, so anyone interested in valuing a firm should welcome infor-
mation on how cash moves in and out of a firm.
Cash Flows
How can a firm obtain cash? Four ways:
• By collecting from customers,

• By borrowing funds from lenders,
1
There may be some minor discrepancies if a firm has different currencies, but for now
we ignore this complexity.
• By obtaining funds from the owners, and

• By collecting on the sale of long-term assets.
As an outside investor looking at a firm, how would you rank these four pos-
sibilities in terms of attractiveness? Finance tells us there is a “pecking order”
for the ways of obtaining cash. Internally generated funds are preferred
over borrowing, which is preferred over equity issues. This means collect-
ing from customers after selling products or services (and hopefully selling
them for more than they cost to produce) would be a firm’s preferred source
of cash. Empirical research in finance tells us there is little or no stock
market reaction when firms borrow funds (so this would be second), but
there is often a negative stock market reaction (share price falls) when a firm
issues new equity (making this number three). Selling long-term assets is
fine if the resources sold are not needed, otherwise this is the least favorable
alternative as it means the firm is either desperate and/or liquidating.
What does a firm use cash for? Again, there are four categories:
• Pay suppliers of goods and services,

• Pay back lenders,
• Provide cash distributions to the owners (in dividends or share
buybacks), and
• Pay for purchases of long-term assets.
Here the ranking is not quite as clear. Many firms like to delay paying
suppliers because they believe this is free financing. Lenders have to be
paid when funds are due, but this can be negotiated. Some owners want
cash distributions while others prefer to have the firm continue to invest
its funds. And, clearly, if a firm has financially attractive projects to invest
in, then the purchase of long-term assets is a good thing.
However, regardless of how one ranks these different cash inflows and
outflows, it is clear that an outsider should find it informative to not
only know the total cash flows in and out of the firm but also have them
categorized. The cash flow statement is categorized in the following ways:
Cash from operations:

Cash received from customers
Cash paid to suppliers of goods and services
Cash Is King 155
Cash from investing:

Cash received from the sale of long-term assets
Cash paid for the purchase of long-term assets
Cash received from the sale of non-operating investments
Cash paid for non-operating investments
Cash from financing:

Cash received from borrowing (new debt issues)
Cash received from the owners (issuing new equity)
Cash paid to reduce debt
Cash given to owners in the form of dividends
Cash given to owners by repurchasing a firm’s own shares
The total of these three categories (cash from operations, invest-

ing, and financing) will exactly match the change in a firm’s cash
balance during the year (calculated by taking the cash account at the
end of the current year minus the cash account at the end of the prior
year).
The Cash Flow Statement can be prepared by reviewing every transac-
tion in a firm’s cash accounts and then categorizing and presenting them
as above. It is simple in concept, but in practice, there may be millions of
transactions.
An analyst evaluating a firm should compare these cash flows to what
is expected given the firm’s economic situation. Think of three different
firms: Firm A is a young, fast-growing firm; Firm B is a stable firm with
flat sales; and Firm C is a firm in decline, slowly liquidating.
What is a possible scenario for cash flow by category for each of these three
firms?
Operations Investing Financing
Firm A (young and fast growing) Negative Negative Positive
Firm B (stable with flat sales) Positive Unclear Unclear
Firm C (declining and liquidating) Positive Positive Negative
What might an analyst expect to see in cash from operations? Consider

Firm A (growing quickly): Cash received from customers is likely to be
lower than the cash paid to suppliers. This is because if sales are increas-
ing rapidly, the firm has to fund receivables and inventory. Payables are
also likely to increase, but the total increase in payables will probably be
less than the total increase in receivables and inventory. Hence, the firm
will have a negative cash flow from operations, which means working
capital (accounts receivables plus inventory less account payable) is flat or
decreasing. By contrast, Firm B is stable and Firm C is declining, so when
it comes to cash from operations, we expect these firms to collect more
than they are paying.
What about cash from investing? This should be the same as cash from
operations for Firms A and C. We would expect Firm A to be investing
in new plant and equipment (cash outflows), whereas Firm C is divest-
ing (cash inflows). Firm B is stable, so it is unclear whether it will grow
slightly, continue to be stable, or shrink slightly.
And what about cash from financing? This is likely to be the op-
posite of cash from operations. A firm must finance any net decrease
in cash from operations and investing. This means Firm A will have
to borrow funds and/or issue new equity to obtain funds because
the cash it is getting from operations does not cover the cost of the
operations (negative cash from operations). By contrast, Firm C is
expected to have excess cash from operations and investing, so it can
pay down debt and/or return cash to the owners. Firm B is stable or
in steady state, so its financing could be slightly positive, or slightly
negative.
Thus, our expectations (and the above is far from complete) of where
cash flows come from and where it goes depends, at least to some extent,
on a firm’s economic life cycle. It is a diagnostic, similar to a doctor tak-
ing someone’s blood pressure. Most medical exams begin with taking an
individual’s blood pressure because it is used as a diagnostic to determine
the subsequent exam.
In addition, cash flows will not always meet expectations, and when
they do not meet expectations, the reader should endeavor to understand
the cause of the difference from expectations. The explanation helps the
reader to understand the firm’s business model.
Cash Is King 157
The Presentation of Cash from Operations

Cash from investing and cash from financing are presented as above.
However, cash from operations is normally presented as a reconciliation
from net income. In this alternate format, cash from operations starts
with net income and then backs out all the noncash accruals, resulting in
the same total as derived from adding the cash collected from customers
and subtracting the cash paid to suppliers. That’s confusing: Why not just
do it as above, by adding the cash collected from customers and subtracting
the cash paid to suppliers? Why start with net income and complicate it? The
reason is to illustrate why (and how) net income differs from cash from
operations. Cannot users just compare the Income Statement and Cash Flow
Statement themselves? They could, but it is considered more informative
to show the reconciliation (i.e., the details of the differences between net
income and cash from operations).2
Some analysts start with an expectation that cash from operations
will be equal or greater than net income plus depreciation (depreciation
is generally the largest noncash expense). If this expectation is met, it
provides a sense of comfort that accounting choices, estimates, and as-
sumptions are not driving net income. Accounting gimmicks may still be
present, but they are perhaps less likely. By contrast, if cash from opera-
tions is less than net income plus depreciation, there is a greater prob-
ability that accounting choices, estimates, and assumptions are driving
net income, and the analyst should examine the financial statements and
accounting choices more carefully.
The order of the Cash Flow Statement’s items normally starts with net
income, then depreciation expense, and then other adjustments (often,
but not always, these would be listed as cash increases, the debits, and
then decreases in cash, the credits).
2
Firms are allowed to provide the cash collected from customers and cash paid to sup-
pliers in addition to the net income to cash from operations reconciliation. Additional
information is always allowed.
Cash from Operations

Let us examine the components of cash from operations in more detail.
We begin using the Balance Sheet and Income Statement to find cash
collected from customers.
How can you estimate cash from customers using a firm’s Balance Sheet
and Income Statement? Take sales and adjust for the change in accounts
receivable. Remember that the formula for calculating the year-end re-
ceivables account is:
Receivablesstart of the year + Sales − Cash Collections

= Receivablesend of the year
The Balance Sheet provides the opening and closing amounts for re-
ceivables, and the Income Statement provides the sales. We solve for cash
collections using simple algebra:
Cash Collections = Sales + Receivablesstart of the year

− Receivablesend of the year
This amounts to:

Cash Collections = Sales + a decrease in receivables over the year, or
Cash Collections = Sales − an increase in receivables over the year
Basically, it is as if the firm collects all the opening receivables, and

then collects sales except for the amounts left as ending receivables. If
receivables decrease during the year, it means the firm collected more cash
than sales. If receivables increase over the year, it means the firm collected
less than the current years’ sales.
How do you find cash paid to suppliers? This is a bit more complicated
because it has two parts. First, the total cost of inventory purchased is
computed. Second, the amount actually paid (remember, we care about
cash paid, not amount purchased) is computed.
We find inventory purchases by using the formula for year-end inven-
tory and using algebra to solve for purchases:
Inventorystart of the year + Purchases − Cost of Goods Sold

= Inventoryend of the year
Cash Is King 159
Purchases = Cost of Goods Sold + Inventoryend of the year

− Inventorystart of the year
Purchases = Cost of Goods Sold + an increase in inventory, or
Purchases = Cost of Goods Sold − a decrease in inventory
Next, we find the amount actually paid by using the formula for
year-end payables:
Payablesstart of the year + Purchases − Cash Payments = Payablesend of the year

Cash Payments = Purchases + Payablesstart of the year − Payablesend of the year
Cash Payments = Purchases – an increase in payables over the year, or
Cash Payments = Purchases + a decrease in payables over the year
What are the implications of one of the variables changing, like payables or
inventory? Holding inventory constant means purchases = cost of goods sold
(essentially, newly purchased inventory exactly replaces the inventory that is
sold during the year). Holding payables constant means the firm pays for
exactly what was purchased. Holding both inventory and payables constant
means the firm paid for cost of goods sold (or cash out = cost of goods sold).
What happens if inventory changes but payables do not? Holding pay-
ables constant: If inventory increases, it means the firm has purchased and
paid more than cost of goods sold. If inventory decreases, it means the
firm has purchased and paid less than cost of goods sold.
What if payables change but inventory does not? If payables increase,
it means the firm has paid less than the cost of goods sold (more unpaid
bills means less cash out). If payables decrease, it means the firm has paid
more than cost of goods sold (less unpaid bills means more cash out).
And what if both inventory and payables change?
Cash Payments = Cost of Goods Sold + an increase in inventory

– a decrease in inventory + a decrease in payables
− an increase in payables
Are we done? Not quite. Changes in other current assets (e.g., prepaid
expenses) and other current liabilities (e.g., accrued expenses) indicate
that there are expenses recorded on the Income Statement that are not
equal to cash paid. In this case, an adjustment similar to the one made
for cost of goods sold is required (the adjustment taking payables into ac-
count) as shown in the next section.
An Illustration
Exhibits 11.1 and 11.2 present a simple Balance Sheet and Income Statement.
Exhibit 11.1
Balance Sheet and changes
End Year 1 End Year 2 Change
Cash 100 110 10
Receivables 200 240 40
Inventory 300 350 50
Prepaid expenses 50 40 (10)
Property, plant, and equipment 500 640 140
Accumulated depreciation (200) (240) (40)
Total assets 950 1,140 190
Payables 260 290 30

Accrued expenses 140 125 (15)
Long-term debt 200 325 125
Contributed capital 300 310 10
Retained earnings 50 90 40
Total liabilities and equity 950 1,140 190
Exhibit 11.2
Income Statement for Year 2
Sales 800
Cost of goods sold 500
Gross profit 300
Depreciation expense 50
All other expenses 180
Operating profit 70
Gain on sale of PP&E 12
Net profit (for simplicity assume no taxes) 82
Cash Is King 161
Computing Cash from Operations

Cash collected from customers = sales less the increase
$760
in receivables ($800 − $40)
Cash paid to suppliers = cost of goods sold plus the increase in inventory
$520
less the increase in payables ($500 + $50 − $30)
Cash paid for expenses = expense less the decrease in prepaid expenses
$185
plus the decrease in accruals ($180 − $10 + $15)
Total cash paid during the year $705
Cash from operations $ 55
Why is depreciation ignored in the above calculation? Because it did not in-
volve an outlay of cash. Likewise, the gain on sale of property, plant, and
equipment (PP&E) is ignored as it also did not involve any cash. Wait
a minute. If PP&E was sold, would there not be some cash received? Yes,
but the cash received, all of it, is included under cash from investments.
Remember, the Cash Flow Statement cares only about cash transactions,
whereas the Income Statement includes noncash items (such as deprecia-
tion expense and gains on sale of PP&E).
The above is the direct computation of cash from operations. How-
ever, as noted, what is normally presented in a Cash Flow Statement is an
indirect computation that shows how to reconcile (adjust) net income to
cash from operations. This would be done as follows:
Net income $ 82
Plus depreciation (this is a noncash expense) $50
Less the gain (plus a loss) on sale of PP&E (this is a ($12)
noncash revenue)
Less the increase (plus a decrease) in receivables ($40)
Less the increase (plus a decrease) in inventory ($50)
Plus the decrease (less an increase) in prepaid expenses $10
Plus the increase (less a decrease) in payables $30
Less the decrease (plus an increase) in accrued expenses ($15)
Net change ($ 27)
Note that cash from operations is the same number under both the
presentations above. It has to be. If it is not, it means . . . you have made
a mistake! That is the beauty of accounting.
Both methods result in the same cash from operations, and firms can
elect either approach. Arguably, the indirect method is preferred because it
provides the link between net income and cash from operations. However,
if a firm chooses the direct method, it must also provide a supplemental
presentation of using the indirect method. By contrast, if a firm chooses
the indirect method, it is not required to provide supplemental informa-
tion using the direct method (i.e., it is one and done). Thus, it may not be
surprising that the vast majority of public firms elect the indirect method.
Computing Cash from Investing

Now let us do cash from investing. As noted above, cash from investing
is (a) cash received from the sale of long-term assets and non-operating
investments and (b) cash paid for the purchase of long-term assets and non-
operating investments. How do we compute the amounts for cash from invest-
ing? First, we need to determine if a long-term asset or investment was sold
or purchased. Second, we have to determine the amount received or paid.
Determining Whether a Long-Term Asset or Investment was Sold

or Purchased
Using our illustration above: Were any assets sold? Yes. How do we know?
This would be information a firm would already have. However, outsid-
ers might find this information in the Notes to the Financial Statements
or perhaps with a gain or loss on the sale of PP&E being itemized on the
Income Statement, as in our current example with Exhibit 11.2. (If there
is a gain or loss on the sale, it means something was sold.) Additionally,
we can use the algebraic equations for PP&E and its accumulated depre-
ciation accounts to determine if anything was purchased or sold.
1. The equation to calculate the year-end value of PP&E for the Bal-
ance Sheet:
PP&Estart of the year + purchases of PP&E − cost of PP&E sold

= PP&Eend of the year
Purchases of PP&E − cost of PP&E sold

= PP&Eend of the year − PP&Estart of the year
2. The equation used to calculate the year-end value of accumulated

depreciation for the Balance Sheet:
Cash Is King 163
Accumulated depreciationstart of the year + depreciation expense

− accumulated depreciation of assets sold
= accumulated depreciationend of the year
Accumulated depreciation of assets sold = accumulated depreciationstart

of the year + depreciation expense − accumulated depreciationend of the year
Inputting the numbers found in Exhibits 11.1 and 11.2 gives us:
Purchases of PP&E − cost of PP&E

= PP&Eend of the year − PP&Estart of the year
Purchases of PP&E − cost of PP&E = $640 − $500 = $140
and
Accumulated depreciation of disposals = accumulated depreciationstart of

the year + depreciation expense − accumulated depreciationend of the year
Accumulated depreciation of assets sold = $200 + $50 − $240 = $10
The PP&E formula (i.e., what happens to the PP&E account from
the start of the year to the end of the year) shows us whether something
was purchased: PP&E increases from $500 at the start of the year to
$640 at the end, so clearly something was purchased (it could not have
increased if there was only a disposal). By itself (without additional in-
formation as discussed below), the equation does not provide the cost of
assets sold or purchased.
The accumulated depreciation formula gives evidence of whether any-
thing was sold. If nothing was sold (or the item sold had no accumulated
depreciation), then the accumulated depreciation account would increase
by exactly the depreciation expense. Here accumulated depreciation in-
creases by $10 less than depreciation expense (depreciation expense was
$50 but accumulated depreciation increased by $40). This means the
item sold had accumulated depreciation of $10.
Besides using the equations above, we can determine if something was
sold by looking at the Income Statement: If the Income Statement lists
a gain or loss on the sale of PP&E, it means something must have been
sold. However, if there is no gain or loss, it could be that the item was
sold for book value or that the gain or loss was small and combined with
another amount when listed on the Income Statement. Thus, knowing
how to use the equations above is still important.
Determining the Amount of Cash Received or Paid for the Asset

Sold or Purchased
The two equations above tell us whether a long-term asset was sold or
purchased and the amount of accumulated depreciation on assets sold.
However, to determine the cost of PP&E sold requires additional infor-
mation on the amount paid for PP&E during the year, which should be
available in the Notes to the Financial Statements.
Once the cost of PP&E is computed, the cash received from the sale
of PP&E is determined by adding a gain or subtracting a loss from the net
book value (the cost of PP&E sold minus the accumulated depreciation on
PP&E sold). For example, assume the Notes to the Financial Statements
indicate the firm purchased new PP&E for $300. This means the origi-
nal cost of the PP&E sold was $160 (PP&Estart + purchases of PP&E −
PP&Eend = $500 + $300 − $640 = cost of PP&E sold). We have already
computed the accumulated depreciation on the asset(s) sold as $10. This
means the net book value (cost − accumulated depreciation) of the PP&E
sold was $150. The gain on the sale as listed on the Income Statement was
$12.3 Thus, the cash received was $162 ($150 + $12), using the logic that:
Cash received from sale = net book value of asset + gain from sale
(or − loss from sale)
The accounting entry would be:

Cash from sale of PP&E $162
Accumulated depreciation 10
PP&E$160
Gain on sale of PP&E 12
3
Note, the gain on the sale of PP&E is not an amount above the original cost of the
PP&E. Rather, the gain is the difference between the cash received and the net book
value (cost less accumulated depreciation) of the asset.
Cash Is King 165
We can now prepare the cash from investing section of the Cash Flow
Statement:
Cash from investing:

Cash received from the sale of long-term assets $ 162
Cash paid for the purchase of long-term assets (300)
Cash from investing ($138)
Note that in the cash from operations, we removed (subtracted) the

gain of $12 because it is a noncash item that is included in net income,
but not in cash from operations. The gain is included in cash from invest-
ing as part of the total cash proceeds received on the sale (which in this
case is the full recovery of the net book value of $150 plus the $12 gain
for a total of $162). Not reducing this amount in cash from operations
would have effectively counted the $12 gain twice.
Computing Cash from Financing

Finally, we compute cash from financing by looking at the changes in
debt and equity as follows:
Cash from financing:

Net cash received from issuing new debt $ 125
Net cash received from issuing new equity 10
Cash dividends paid (42)
Cash from financing $ 93
Note that in the example above, the amount shown is the net cash
from issuing new debt and the net cash from issuing new equity. In fact,
the amounts should be separated (as shown at the start of this chapter)
into cash paid to retire debt and cash received from new debt as well as
cash paid to repurchase shares and cash received from issuing new shares.
As with PP&E, these specifics can be computed only with additional in-
formation (ignored here for simplicity).
To compute the cash dividends paid, we return to the algebra of the
retained earnings account:
Retained earningsstart of the year + income (or − loss) − dividends

= retained earningsend of the year
Dividends = retained earningsstart of the year + income (or − loss)

− retained earningsend of the year
Dividends = $50 + $82 − $90 = $42
The “dividends” amount above is in fact dividends declared. However,

if any declared dividends had not been paid at year-end, there would be
a dividends payable account (a liability) and any increase (decrease) in
dividends payable would reduce (increase) the cash dividends paid. Thus,
the cash paid for dividends is:
Cash dividends paid = dividends + dividends payablestart of the year
− dividends payableend of the year
Putting the Cash Flow Statement Together

Putting the three sections together we have:
Cash flow for the year-ended Year 2

Net income $ 82
Plus depreciation (this is a noncash expense) $50
Less the gain on sale of PP&E (this is a noncash revenue) ($12)
Less increase in receivables ($40)
Less increase in inventory ($50)
Plus decrease in prepaid expenses $10
Plus increase in payables $30
Less decrease in accrued expenses ($15)
Net change ($ 27)
Cash received from the sale of long-term assets $162
Cash paid for the purchase of long-term assets ($300)
Cash from investments ($138)
Net cash received from issuing new debt $125
Net cash received from issuing new equity $ 10
Cash dividends paid ($ 42)
Cash from financing $ 93
Increase in cash during the year $ 10
Opening cash balance $ 100
Closing cash balance $ 110
Cash Is King 167
Once again, the math works (if it does not, it means there is a mistake).
How could this Cash Flow Statement be interpreted? Perhaps this is
an established firm, which is still growing. The firm is throwing off
cash from operations but not enough to finance its new investment in
PP&E, so the firm still has to obtain funds from debt and equity. With-
out the new investment in PP&E (net PP&E is substantially more than
the depreciation expense, reflecting a growing firm), the firm would
have enough cash from operations to pay all its dividends and still pay
down some debt or buy back some shares. Because the firm does not
have enough cash from operations to fund the new PP&E and still
chooses to pay dividends, it requires even more financing than it would
otherwise.
A Few Additional Points

How is the category (operations, investing, or financing) for each item
determined? It is based on the nature of the account. Is the account
related to operations, purchasing new PP&E, or financing activities? Re-
ceivables, inventory, prepaid expenses, payables, and accruals are all
part of operations. It is also a convention (as noted above) to start
with net income and have depreciation listed second, followed by the
others (often listing the debits first and the credits second, but this is
not required).
As a rule of thumb, changes in assets can only be operations or invest-
ing (and current assets are usually in operations with the exception of
short-term investments, which are not part of operations and are there-
fore included in cash from investing). Liabilities and equity accounts can
only be in operations or financing (and again, short-term items are nor-
mally in operations).
Note that firms create their Cash Flow Statements by examining
their cash accounts. This means a Cash Flow Statement created by
an outsider using the Balance Sheet, Income Statement, and some
limited additional information may not exactly match what the firm
prepares.
One last point: In the United States, interest expense is included in

cash from operations (it is included in net income and no adjustment is
required). In most European countries, interest expense is included in
cash from financing (so it must be added back to or canceled out of net
income and then reduced in cash from financing). There are often similar
minor differences across countries.
Free Cash Flow

Many people incorrectly think that cash from operations is the same as
the finance concept of free cash flow.4 The two are not the same.
Free cash flow is usually computed as the net cash flow generated
by a firm’s assets or by its asset-based activities. It is the total cash
available for distribution to the creditors and owners after funding all
worthwhile investment activities. This is NOT the same thing as cash
from operations, which is the cash received from customers and paid
to suppliers.
The computation of free cash flow in finance is:
EBIT × (1 − tc) + Depreciation Expense − Change in Working
Capital − Net Capital Expenditures,
where EBIT stands for Earnings before interest and taxes, tc stands for the
corporate taxation rate, and
Change in working capital = change in receivables + change in
inventories − change in payables
The Bottom line

While cash flows do represent a truth (the firm has the cash or it does
not) they are subject to manipulation by altering the underlying econom-
ics (speeding up or delaying cash flows). By itself, the cash flow state-
ment is not as informative as the Balance Sheet and Income Statement.
4
An even worse approximation for free cash flow is net income plus depreciation (this
crude estimate is often referred to as a “banker’s free cash flow”).
Cash Is King 169
Combined with the other statements, understanding the cash flows pro-
vides an additional tool in understanding the economics of a firm.
The next chapter begins to bring all the numbers together using ratio
analysis as a starting point to diagnose a firm’s health and determine its
key economic drivers. It ends this volume. But first, Appendix 11A pres-
ents a simplified method for an outsider to produce cash flow statements.
APPENDIX 11A
Another Way to Create Cash Flow

Statements (A Simple Debit and
Credit Approach)
If you are comfortable with debits and credits, the Cash Flow Statement
can be prepared by creating T accounts for all Balance Sheet items and
adjusting all changes to the cash account.5 This is done by creating a
large T account for cash divided into three sections (Operations, Invest-
ing, and Financing) and smaller T accounts for everything else. Then,
for each change (debit or credit) required to adjust each account (other
than cash) from its opening to closing balance, a corresponding opposite
change (credit or debit) is made into the large cash T account. Let us do
this for our example above.
For each small T account below, the opening and closing numbers are
in bold and the required entry to balance the specific account is in ital-
ics. Whatever entry is required in the small T account to balance (a debit
or credit), the opposite entry (a credit or debit) is made in the large cash
T account below. The entries are numbered in parentheses to help you
match them with the numbers in the cash T account. Underneath each
small T account is also a written description of the impact to the small T
account and cash.
5
This can also be done on a spreadsheet with plusses and minuses, but using debits
and credits can reduce mistakes.
APPENDIX
171
Receivables Inventory Other CA

Open $200 | Open $300 | Open $ 50 |
(1) $ 40 | (2) $ 50 | | $ 10 (3)
Close $240 Close $350 Close $ 40
Receivables ↑ Cash ↓ Inventory ↑ Cash ↓ Other CA ↓ Cash ↑
PP&E Accumulated Depreciation

Open $ 500| |$ 200 Open
(4) Additions $ 300| Sale $160 (5) (5) Sale $ 10 |$ 50 Depreciation Expense (6)
Close $ 640| | $240 Close
PP&E ↑ Cash ↓ Accumulated Depreciation ↑ Cash ↑
Payables Accruals Long-Term Debt

| $260 Open | $140 Open | $200 Open
| $ 30 (7) (8) $ 15 | | $125 (9)
| $290 Close | $ 125 Close | $325 Close
Payables ↑ Cash ↑ Accruals ↓ Cash ↓ Long-Term Debt ↑ Cash ↑
Contributed Capital Retained Earnings

|$ 300 Open | $ 50 Open
| $ 10 new issue (10) (12) Divd. $ 42 | $ 82 Net Income (11)
|$ 310 Close | $ 90 Close
Capital ↑ Cash ↑ Dividends ↑ Cash ↓ & Net Income ↑ Cash ↑
(Note that CA stands for current assets, CL for current liabilities, and
Divd. for dividends.)
172 APPENDIX
The opposite of each adjustment (in italics above) is then entered into the
cash T account below.
Cash
Open $100 |
|
Net income (11) $82 |
Depreciation (6) $50 |
Loss PP&E n/a | Gain PP&E $12 (5)
Decrease receivable n/a | Increase receivable $40 (1)
Decrease inventory n/a | Increase inventory $50 (2)
Decrease other CA (3) $10 | Increase other CA n/a
Increase payables (7) $30 | Decrease payables n/a
Increase other CL n/a | Decrease other CL $15 (8)
Cash from operations $55 | Cash from operations
|
Cash from sale of PP&E (5) $162 | Cash from purchase of PP&E $300 (4)
Cash from investments | Cash from investments $138
|
Cash from debt (9) $125 | Cash paid to retire debt n/a
Cash from new equity (10) $ 10 | Cash paid to retire equity n/a
| Cash dividends paid $42 (12)
Cash from financing $ 93 | Cash from financing
Net change in cash $ 10 | Net change in cash

Closing cash $110 |
Cash from operations = +$ 55

Cash from investing = −$138
Cash from financing = $ 93
Net change in cash = $ 10
To explain the T account entries above:
(1) Opening receivables is a debit balance of $200, and there is a closing

debit balance of $240. This means a total net debit of $40 is required
to go from the opening to the closing balance in receivables. The
APPENDIX
173
corresponding entry to cash is a credit of $40. The firm collected the

opening receivables plus this year’s sales less the closing receivables.
If receivables increase, it means the firm collected less than this year’s
sales. So cash decreases.
(2) Opening inventory is a debit balance of $300, and there is a closing
debit balance of $350. This means a net debit of $50 is required to
go from the opening to the closing balance in inventory. The corre-
sponding entry to cash is a credit of $50. Cash decreases because in-
ventory increases: All else equal, this means the firm purchased and
paid for more inventory than the cost of goods sold (e.g., remember
above, we first determined purchases and then amounts paid).
(3) Other current assets (like prepaid expenses) has an opening debit
balance of $50 and a closing debit balance of $40. This means a net
credit of $10 was made during the year. Thus, a net debit of $10
is made in the large T account for cash. If there were no change in
other current assets, then the other expense amount on the Income
Statement would match the cash paid. Because the other asset ac-
count went down, this means the amount of cash the firm paid for
other expenses is less than the amount recorded on the Income State-
ment, which means the firm has more cash at the end of the year.
(4) The accounts of property, plant and equipment (PP&E) and related
accumulated depreciation require more adjustments as explained
above. Here, we do not just have the opening, closing, and one net
debit or credit. Instead, we have multiple entries (in this case, one
debit and one credit to each account). The $300 debit to PP&E is
for the purchased assets. The corresponding amount is a credit to
cash (as this is the actual cash paid for PP&E during the year). This
amount is included in cash from investments. Cash went down by
this amount because it is a payment of cash for PP&E.
(5) This records the cash received from the sale of PP&E. Note that the
proceeds for the sale of PP&E are $162. This is computed from the
net book value of $150 ($160 cost of PP&E less the $10 related ac-
cumulated depreciation on the asset sold) plus the gain of $12. The
total $162 cash received from the sale of PP&E is reported as a debit
under cash from investing. However, the sale of PP&E also affects
cash from operations. The $12 gain from the sale of PP&E must
174 APPENDIX
be subtracted from the net profit included in cash from operations

in order to avoid double counting it. Remember, we are including
the $12 gain under cash from investing as a part of the total $162
in proceeds from the sale of PP&E. Leaving the $12 gain in cash
from operations would include the $12 in two places, and the final
change in cash computed on the cash flow will be $12 higher than
the actual change in the opening and closing cash balance (again, the
joy of balancing).
(6) The $50 credit to accumulated depreciation represents deprecia-
tion expense. This is a debit to cash from operations. If deprecia-
tion expense is related to long-term assets, why is it not included under
cash from investing? Depreciation is a noncash expense. That is, the
amount reduced net income but there was no cash flow. The related
cash flow occurred when the asset was paid for: The entire payment
was included, added back, as a reduction in cash from investments
at the time of payment. Depreciation expense is included under cash
from operations in order to remove the noncash expense from net
income.
(7) Payables have an opening credit balance of $260 and a closing credit
balance of $290. This means the account had a net increase (credit)
of $30. This is related to item (2) above in determining how much
cash was paid for inventory. Cash from operations increases (with a
debit) because an increase in payables means less cash was paid dur-
ing the year.
(8) Accrued expenses have an opening credit balance of $140 and a clos-
ing credit balance of $125. This means the account had a net de-
crease (debit) of $15. Cash from operations goes down (is credited)
because more cash was paid than the stated amount on the Income
Statement.
(9) Long-term debt has an opening credit balance of $200 and a clos-
ing credit balance of $325. Above we assume that no debt is paid
back, which means $125 was received for new debt issued. However,
if debt was retired and new debt was also issued, both the retire-
ment and issue should be shown on the statement because we want
to capture all cash flows, in or out, and not just net amounts. For
example, if $75 of debt was retired and the long-term debt balance
APPENDIX
175
still increased by $125, it means there was $200 in new debt issued
(opening balance of $200 + new debt of $200 2 debt retired of $75
= ending balance of $325).
(10) Contributed capital has an opening credit balance of $300 and a
closing credit balance of $310. This means the account had net new
equity issued (a credit) of $10 (i.e., cash up net $10, contributed
capital up net $10). As with long-term debt, if some equity was re-
purchased but the ending balance remained the same, it means more
new equity had been issued. Assuming no equity was repurchased,
the net increase in cash from financing is (debited) $10.
(11) Retained earnings have an opening credit balance of $50 and a clos-
ing credit balance of $90. We see that the account increases (a credit)
by the net income of $82. The corresponding amount (debit) is in
cash from operations.
(12) Finally, we note that opening retained earnings plus net income is
more than ending retained earnings. This means that a dividend was
paid (a debit in the retained earnings account). The amount required
to balance is $42. In the cash T account, this is a credit to cash from
financing.
CHAPTER 12
Financial Statement Analysis
This chapter introduces traditional financial analysis on a firm. It is the

process used to evaluate a firm’s financial health and the starting point in
predicting its future cash flows.
Are the Numbers Reasonable?

Garbage In Garbage Out: First check if the raw data is reasonable.
Financial analysis should start by reviewing the numbers in the finan-
cial statements to check whether they make sense. First, does the growth
in revenue seem reasonable (or plausible)? For example, in the scandal that
engulfed the insurance firm Equity Funding Corporation of America in
1973, revenues were growing at 67 percent a year for 7 years.1 Today this
may seem like a firm doing extremely well. However, back in the late
1970s, this growth rate made Equity Funding one of the fastest-growing
firms in America. Was it possible? Perhaps. Was it likely, given that Equity
Funding was an insurance firm, the insurance industry’s average growth rate
at the time was 5 percent, and the next best growth rate of any firm in the
industry was 12 percent? It certainly seems questionable. What allowed
Equity Funding to report growth that was more than five times the number
two player and 13 times the industry average? Massive fraud.
Second, still looking at whether the financial statements make sense, is the
absolute level of each number plausible? For example, in the infamous Salad
1
Equity Funding filed for bankruptcy on March 30, 1973, at a time when the media
was fixated on the Watergate scandal involving President Richard Nixon (Nixon tried to
cover up a break-in to the offices of the Democratic National Committee at the Water-
gate office complex in the District of Columbia, ordered by members of his staff). The
break-in occurred on June 17, 1972. On April 30, 1973, President Nixon asked for the
resignation of his top two aids. President Nixon himself resigned on August 8, 1974.
Oil Swindle of 1963, the Allied Crude Vegetable Oil Refining Company
(Allied) claimed sales of $250 million, which represented 75 percent of
total U.S. exports of cottonseed and soybean oil. Allied leased approxi-
mately 100 tanks to store the oil, with a total capacity of about 500 mil-
lion pounds of vegetable oil, yet the firm claimed to have 1.8 billion
pounds of oil in inventory. At the time, the United States exported about
1.2 billion pounds a year. Thus, Allied’s 1.8 billion pounds represented
1.5 times the total U.S. annual exports. Did it made sense for this one firm
to have that quantity of inventory? Definitely not. When Allied filed for
bankruptcy on November 19, 1963, the firm had only about 100 million
pounds of various substances in the tanks (mostly water and sludge, not
oil). Allied’s $100 million purported worth of vegetable oil turned out to
be, in reality, a mere $6 million worth.2
Components of Financial Analysis

Financial analysis (also called ratio analysis) is a diagnostic tool. It is a
starting point in understanding a firm’s underlying economics and mea-
suring its financial health and performance. Ratios by themselves have
little or no meaning. There is no magic number above or below which a
ratio has to be. Rather, ratios must be compared to something, e.g., what
is expected, a trend over time, the ratios of other firms, and/or industry
averages. Understanding why a firm’s ratios differ from expectations help
analysts understand what is happening in a firm.
There are four main categories of ratios: profitability, activity, leverage,
and liquidity. Each will be discussed in turn below.
Profitability
Imagine two firms, one having a net profit of $5 million and the other
having a net profit of $40 million. Which firm has done better? Clearly the
second firm has earned more, but the profits do not tell the whole story.
For example, if the first firm earned the $5 million with an investment of
2
The Allied Vegetable bankruptcy filing on November 19, 1963, was overshadowed by
President John F. Kennedy’s assassination on November 23, 1963.
Financial Statement Analysis 179
$25 million (a 20 percent return), whereas the second firm earned $40
million on an investment of $400 million (a 10 percent return), we might
feel the first firm did better. In other words, there is more to determining
a firm’s profitability than just looking at the total profit earned.
There are three main types of profitability ratios, of which profit di-
vided by amount invested as noted above is just one:
Profit margins. This ratio essentially measures the return, or profit, on
a dollar of sales revenue. It can be computed for various levels of profit
(e.g., gross profit, operating profit, net profit, and so on). The numerator
is the profit number, the denominator is the sales number.
Gross Profit / Sales

Operating Profit / Sales
Net Profit / Sales
Return on Assets (ROA) looks at the profit given the total resources
available, independent of how the resources were financed. The numera-
tor is net profit adjusted for the cost of financing net of any tax effects.
The denominator is the total resources available.
ROA = (Net Income + Interest Expense (1 − the tax rate)) / Total Assets
To explain a bit more: Imagine you have two firms, both earning
$100 million before finance charges and taxes. The first firm has financed
the resources entirely with equity. The second firm has financed with both
debt and equity, and has an annual interest charge of $20 million. If the
corporate tax rate is 30 percent, the first firm will have net profit of $70
million, whereas the second firm will have net profit of $56 million.
Firm A Firm B
Profit before interest and taxes $100 $100
Interest expense $ 0 $ 20
Profit before taxes $100 $ 80
Taxes (30 percent of profit before taxes) $ 30 $ 24
Net profit $ 70 $ 56
Considering profitability while explicitly excluding how the resources

were financed requires adjusting for the cost of financing. However, simply
adding back the interest expense (which would then have Firm B showing
an adjusted profit of $76 million) is incorrect because the interest charges
are tax deductible. Essentially, the government shares the cost of financ-
ing by allowing the firm to reduce taxable income by the interest expense.
The government thus picks up $6 million of the total cost of financing
(which can be seen in the difference in the tax of the two firms, $30 million
vs. $24 million), and the true cost to Firm B of financing is $14 million,
or interest minus tax savings (calculated as the $20 million in interest × [1
− the tax rate]). We can make the two firms’ profits directly comparable
by adding back Firm B’s after-tax financing charge of $14 million.
Firm A Firm B
Profit before interest and taxes $100 $100
Interest expense $ 0 $ 20
Profit before taxes $100 $ 80
Taxes (30 percent of profit before taxes) $ 30 $ 24
Net profit $ 70 $ 56
Add back after tax cost of interest $ 0 $ 14 ($20 × 70%)
Adjusted profit ignoring cost of financing $ 70 $ 70
Return on Equity (ROE) measures the return to a specific investor

group: the owners. No adjustment is made to the numerator because bor-
rowing well (or poorly) is part of the net return to the owners.
ROE = Net Income / Owner’s Equity
Doing the Math

There are hundreds if not thousands of different ratios, making it critical
to understand their exact definitions and to be consistent across time and
firms. It is also important to ensure the calculation is being done correctly.
For example, when computing the profit margins above, an Income State-
ment number is divided by an Income Statement number (e.g., Net In-
come / Sales). As long as the same Income Statement is used, there should
be no problem. However, for ROA and ROE, the Income Statement num-
ber is divided by a Balance Sheet number, which leads to the questions:
Which Balance Sheet? The opening Balance Sheet (last year’s close), the clos-
ing Balance Sheet (this year’s close), or some average (simple average, monthly
average, and so on)? Surprisingly, most textbooks suggest using the simple
average (opening number / 2 + closing number / 2). However, unless the
firm is continuously investing more funds, this makes no sense. Imagine
investing $1,000 in a bank account, earning $50, and ending the year with
$1,050 in the bank account. What is the return? It is not 4.88 percent ($50
/ $1,025), using the average of the two investment amounts. It is not 4.76
percent ($50 / $1,050), using the ending number. Rather, it is 5 percent
($50 / $1,000), using the initial investment or opening number.
Often year-end numbers are used because they are readily available
and being more precise would not result in a material difference (this is
true when the opening and closing numbers are not materially different).
Still, it is important to know and understand the choice used.
Appendix 12A provides selected financial information for Apple Inc.
along with calculations for the ratios discussed. As can be seen Apple
maintained a gross profit margin of about 40 percent and a profit mar-
gin of about 23 percent from 2012 through 2015. Thus, Apple gener-
ates $0.40 gross and $0.23 net per $1.00 of sales. Its return on assets
average 21 percent with ROE averaging 37 percent from 2013 to 2015
(note to calculate the 2012 ratios requires the opening Balance Sheet
numbers for 2012—which are the ending numbers for 2011). These are
extraordinarily high ratios for any firm and explain Apple’s high market
value.
Activity
Activity ratios focus on the firm’s operations. Below are a few possible
activity ratios:
Days Receivable = Receivables / (Sales / 365)

Days Inventory = Inventory / (Cost of Goods Sold [COGS] / 365)
Days Payable = Payables / (Purchases / 365)
Fixed Asset Turnover = Sales / Fixed Assets
Total Asset Turnover = Sales / Total Assets
The first three ratios reflect how well a firm is managing its collec-
tions and inventory and how long the firm is taking to pay its suppliers.
The last two indicate the amount of fixed assets (property, plant, and
equipment [PP&E]) and total assets the firm needs in order to gener-
ate sales. Changes in these last two ratios are often related to changes
in revenue.
Appendix 12A shows Apple’s ratios are consistent over the last few
years. Apple took 26 days to collect in 2015. This reflects the combina-
tion of sales to third party vendors (e.g., phone companies) as well as di-
rectly to consumers (whose payment with credit cards would be received
by Apple a day or two after the sale). Apple’s 2015 ratio of 6 days of
inventory reflects a very efficient operation. At the same time, Apple takes
115 days to pay its suppliers. Days receivable plus days inventory less days
payable is often referred to as net working capital. For most firms, net
working capital is a positive number reflecting the amount of financing
the firm requires for net working capital (days receivable plus days inven-
tory less days payable). For Apple, it is a negative number (26 days +
6 days − 92 days = −60 days). Thus, Apple is using its large purchasing
power to essential extract financing from its suppliers. Apple’s fixed asset
turnover of almost 11 indicates the firm does not require much PP&E for
operations. The total asset turnover is less the 1 because of the enormous
amount of cash and marketable securities held by Apple.
Leverage
Leverage measures how a firm has funded its resources: the split between
debt and equity. It is a measure of long-term risk. All else equal, the greater
the funding from debt, the greater the risk that the firm will be unable to
repay the debt and the greater the probability of bankruptcy.
Although there are many different ways to do the actual calculation,
there are really two key differences in how this risk is calculated. One set
of approaches counts only interest-bearing debt as debt (i.e., it excludes
accounts payable, deferred taxes, and other such liabilities), whereas the
other includes all liabilities as debt.
Debt / (Debt + Equity), where Debt is interest bearing

Total Liabilities / Total Asset
Total Assets / Owner’s Equity
Times Interest Earned = Earnings Before Interest and Taxes / Interest
Expense
Note the second and third ratio above measure exactly the same
thing. The second ratio may be more intuitive, whereas the third fits into
the DuPont equation discussed below. The last ratio is an example of

adapting a ratio to a specific user: Times Interest Earned is a banker’s ratio
as it indicates whether a firm has enough funds to pay the interest on
debt. A number less than one means the firm will not have enough funds
to pay. The higher the number, the better the banker sleeps at night.
Appendix 12A indicates Apple is financed mostly with contributed
capital and retained earnings. However, one may wonder why Apple has
any debt given its cash and marketable securities balances. The reason
is that much of the firm’s profit is overseas and would be subject to ad-
ditional taxes if repatriated to the United States. Thus, Apple finds it less
costly to borrow funds (which it can do at very low rates given its high
profitability and low risk) to pay out dividends and buy back shares.
Liquidity
Liquidity is a measure of short-term risk. It considers whether the firm
has the ability to pay its current debts as they come due. The two key
liquidity ratios are:
Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Cash + Marketable Securities + Receivables) / Current
Liabilities
The quick ratio is basically a more conservative version of the current

ratio: It only includes those assets that could be quickly converted to cash
if needed to repay current debts. Thus, inventory and prepaid expenses
are excluded.
Appendix 12A indicates Apple Inc. has very large liquidity ratios in-
dicating the firm’s low risk of not paying its debts as they come due. This
makes sense given the firm’s cash and marketable security balances.
Other Ratios
There are numerous other ratios that are used to measure specific areas of
a firm. For example, advertising expenses or research and development
expenses as a percentage of sales. These ratios indicate whether a firm is
trying to expand its market share and product line or perhaps is cutting
back to improve short-term profits (potentially at the cost of long-term
profitability).
Sales / Employees and Fixed Assets / Employees used to be very popu-
lar ratios. The idea was to measure the efficiency of employees (how much
sales each employee generated and how much fixed assets are required per
employee). Of course, a firm could improve these ratios by outsourcing,
which is why it is so important for the analyst to consider any substantial
change in the denominator and its cause.
Common Size Financial Statements

Dividing all financial statement numbers by sales produces what is called
common size financial statements. Essentially, all components (line items)
of the Income Statement and Balance Sheet are transformed into percent-
ages of sales (i.e., are divided by sales). This allows for comparisons over
time (both for the individual firm as well as to other firms), eliminates the
impact of differences in size, and provides a starting point for forecasts.
An alternative Common Value Balance Sheet divides all Balance Sheet
numbers by total assets. Again, this allows for comparisons over time and
across firms.
DuPont Analysis
The DuPont Model3 says that a firm’s ROE is the product of its profit-
ability (selling stuff for more than it cost), its capital intensity (sell-
ing stuff without excess resources), and its financial leverage (financing
well). These are measured by Net Income / Sales, Sales / Assets, and
Assets / Equity, respectively. (Assets / Equity is the less-than-intuitive
leverage ratio introduced above, which you can now see fits nicely into
the DuPont formula). There are therefore three levers by which a firm
can increase ROE.
3
Named after the DuPont Corporation, which first started talking about this type of
analysis over a hundred years ago.
DuPont Formula:
ROA = Net Income4 × Sales
Sales Total Assets
ROE = Net Income × Sales × Total Assets

Sales Total Assets Equity
Which can be stated in words as:

ROE = Profitability × Capital Intensity × Leverage
ROE can be increased by an increase in profitability and/or capital

intensity and/or leverage. If you calculate the cross products in the above
equation, sales cancels with sales and assets cancels with assets, leaving
you with ROE = Net Income / Equity, or the net income return per
dollar of equity. However, it is useful to consider each component of the
DuPont Formula, instead of just the simplified Net Income / Equity, be-
cause each of the three levers are useful for analysis.
The Bottom Line

You should now be able to pick up an annual report, read it, understand
much of it, and have a solid foundation to start asking questions about
the firm. Hopefully this book showed you that accounting can be fun and
informative, or at least that it is not as painful as you feared. This ends this
book. Accounting for Fun and Profit: Understanding Advanced Topics in
Accounting presents many of the more complex aspects of accounting.
4
Note that net income really should be adjusted here for interest net of taxes, but this
is often not done in DuPont Analysis to facilitate the move from ROA to ROE. Also,
the figure for total assets in the asset turnover formula is often the year-end number so
it matches (and cancels out) the amount used in the leverage ratio.
APPENDIX 12A
Apple Inc. Selected Financial

Information
Year ($ millions) 9/26/2015 9/27/2014 9/28/2013 9/29/2012

Net sales 233,715 182,795 170,910 156,508
Cost of sales 140,089 112,258 106,606 87,846
Gross margin 93,626 70,537 64,304 68,662
Research and 8,067 6,041 4,475 3,381

development
Selling, general, and 14,329 11,993 10,830 10,040
administrative
Operating income 71,230 52,503 48,999 55,241
Other income 1,285 980 1,156 522

(expense), net
Income before 72,515 53,483 50,155 55,763
income taxes
Provision for income 19,121 13,973 13,118 14,030

taxes
Net incomes 53,394 39,510 37,037 41,733
Earnings per share 9.22 6.45 5.68 6.31

(diluted)
Cash dividends 1.98 1.82 1.64 0.38
APPENDIX
187
Year ($ millions) 9/26/2015 9/27/2014 9/28/2013 9/29/2012

Cash + marketable 41,601 25,077 40,546 29,129
securities
Accounts receivable 16,849 17,460 13,102 10,930
Inventories 2,349 2,111 1,764 791
Other current assets 28,579 23,883 17,874 16,803
Current assets 89,378 68,531 73,286 57,653
Long-term 164,065 130,162 106,215 92,122

marketable
securities
PP&E 22,471 20,624 16,597 15,452
Other long-term 14,565 12,522 10,902 10,837
assets
Total assets 290,479 231,839 207,000 176,064
Short-term debt 10,999 6,308 - -

(including current
portion)
Accounts payable 35,490 30,196 22,367 21,175
Other current 34,121 26,944 21,291 17,367
liabilities
Current liabilities 80,610 63,448 43,658 38,542
Long-term debt 53,463 28,987 16,960 -

Other noncurrent 37,051 27,857 22,833 19,312
liabilities
Total liabilities 171,124 120,292 83,451 57,854
Contributed capital 27,416 23,313 19,764 16,422

Retained earnings 92,284 87,152 104,256 101,289
Other (345) 1,082 (471) 499
Shareholders’ equity 119,355 111,547 123,549 118,210
Total liabilities and 290,479 231,839 207,000 176,064

equity
188 APPENDIX
9/26/2015 9/27/2014 9/28/2013 9/29/2012
Profitability
Sales growth (%) 27.9 7.0 9.2 44.6
Gross profit margin: gross 40.1 38.6 37.6 43.9
profit / sales (%)
Net profit margin: net 22.8 21.6 21.7 26.7
income / sales (%)
Return on assets: net 23.0 19.1 21.0 n/a
income / total assetsopen
(%)
ROE; net income / 47.9 32.0 31.3 n/a
equityopen (%)
Activity
Days receivable: 26.31 34.86 27.98 25.49
receivables / (sales / 365)
Days inventory: inventory 6.12 6.86 6.04 3.29
/ (COGS / 365)
Days payable: payables / 92.31 97.88 75.89 n/a
(purchases / 365)
Fixed asset turns: sales / 10.85 9.82 10.67 n/a
PP&Eaverage
Total asset turns: sales / 0.89 0.83 0.89 n/a
total assetsaverage
Leverage
Debt: debt / (debt + 35.1 24.0 12.1 0.0
equity) (%)
Leverage: total assets / 243.4 207.8 167.5 148.9
equity (%)
Liquidity
Current: current assets / 110.9 108.0 167.9 149.6
current liabilities (%)
Quick: quick assets / 72.5 67.0 122.9 103.9
current liabilities (%)
Index
Accounting Balance sheet, 15–21, 28–31
accrual basis of, 49–58 assets, 28
cash basis of, 21, 50 and income statement, 41–44
for current liabilities, 97 liabilities, 29
description of, 1 owners’ equity, 29, 143–151
economic concept of, 21 presentation of, 29–30
information, 1 spreadsheet, 47
introduction to, 1–13 Bank debt, 97–98
for payables, 98 Bonds, 127
process of, 27–44 accounting for, 132–135
system, 1, 41 callable, 130
traditional methods, 17–20 convertible, 130–131
Accounts receivable, 63–64 ratings, 131–132
aged, 71–74 redeemable, 130
Accounts payable, 35, 98 serial bond (mortgage), 136
description of, 35 terms of, 127–128
Accrual accounting, 49–58 valuation, 122–126
expense, recognition of, 54–56 zero-coupon, 135
revenue, recognition of, 50–54 Bookkeeping, 27
Accrued expenses, 109
Accumulated depreciation, 94 Callable bonds, 130
Activity ratios, 181–182 Cash, 59–61, 153–175
Advances, 99 accounting, 21
Adverse opinion, 12 from financing, 165–166
Aged accounts receivable, 71–74 from investing, 162–165
Amortization, 96 obtaining, 153–154
Annual depreciation, 89 from operations, 157–162
Annual percentage rate (APR), 116 used for, 154
Annual report, 2 Cash flow statements, 170–175
covers of, 6 categorizing, 154–155
and customers, 4 Common size financial statements, 184
and government, 4 Compound entry, 45
inside of, 8–12 Compounding, 111, 113–115
opinions and, 9–12 Contract rate, 128
order of, 12–13 Contributed capital, 143–146
purpose of, 3 Convertible bonds, 130
reading of, 13 Corporate bonds, 127
and senior management, 3–4 Coupon rate, 122, 128
Annuities, 116–122 Coupons, 122
Annuity due, 119–122 Covenants, 129
Assets, 15–22, 28 Credit, description of, 31
AVG, 17–18, 20 Cumulative preferred shares, 146
190 INDEX
Current assets Equity, 15–22

accounts receivable, 63–64 Estimated warranties, 109
aged accounts receivable, 71–74 Ex-dividend date, 147
cash, 59–61 Expense, recognition of, 54–56
inventory, 74–82
LIFO versus FIFO, 80–83 Face value, 128
market securities, 61–62 of bond, 122
others, 85 Fair value reporting, 21–22
percentage of sales, 65–71 FIFO, 17–19
Current liabilities, 97–109 versus LIFO, 80–83
advances, 99 Finance, cash and, 165–166
bank debt, 97–98 Financial statement analysis, 177–188
deferred income tax, 99–108 activity, 181–182
long-term debt, current maturity calculations, 180–181
for, 98 common size statements, 184
others, 108–109 components of, 178
payables, 98 DuPont analysis, 184–185
leverage, 182–183
Dates, dividends liquidity, 183
declaration date, 147 other ratios, 183–184
ex-dividend date, 147 profitability, 178–180
payment date, 147 Fixed price tender, 148
record date, 147 Free cash flow, 168
Debentures, 130 Future value (FV), 112–113
Debit, description of, 31
Declaration date, 147 GAAP. See Generally accepted
Deferred income tax, 99–108 accounting principles
Deferred tax asset, 108 General ledger, 31
Deferred tax liability, 107 Generally accepted accounting
Denial of opinion, 12 principles (GAAP), 10
Depletion, 96 Gross profit, 56
Depreciation
accumulated, 94 Income statement, 38–41, 48, 56–58
annual, 89 and balance sheet, 41–44
straight-line, 89 spreadsheet, 47
Discounting, 111–115 Intangible assets, 89, 96
Discount rate, 128 Interest rates, 115–116
Discounts, 138–140 Inventory, 74–82
Dividends, 29, 39, 147 Investment
dates and, 147 and cash, 162–165
payable, 98 grade, 131–132
Double declining balance, 90
DuPont analysis, 184–185 Leverage, 182–183
Dutch auction tender, 149 Liabilities, 15–22, 29
LIFO, 18–20, 22
Effective rate, 128 versus FIFO, 80–83
method, 140 Liquidity, 183
INDEX
191
Liquid market, 22 Property, plant, and equipment

Long-term assets, 87–96 (PP&E), 88–96
Long-term debt, 127–141 Public relations tool. See
bonds. See Bonds Annual report
current maturity for, 98
discounts, 138–140 Ratio analysis. See Financial
maturity of, 141 statement analysis
premiums, 138–140 Redeemable bonds, 130
Long-term marketable Returnable deposits, 108–109
securities, 87 Return on Assets (ROA), 179
Return on Equity (ROE), 180
Market rate, 128 Revenue, recognition of, 50–54
Market securities, 61–62 Reverse splits, 151
Market value. See Price value Ross, John, 83–85
Maturity value, 128
Mortgage bonds, 136 Sarbanes–Oxley Act, 25
Serial bonds, 136
Natural resources, 89, 96 Share repurchases, 148
Net profit, 56 Spreadsheet
Noncurrent assets, 96 with balance sheet entries, 47
Nonfinancial amounts, 144 with income statement items, 47
Stated rate. See Coupon rate
Open market purchases, 148 Statement of profit or loss, 39
Operating profit, 56 Stock dividends, 149–151
Operations, cash and, 157–162 Stock splits, 149–151
Ordinary annuity, 119–122 Straight-line depreciation, 89, 139
Owners’ equity, 29, 143–151
contributed capital, 143–146 T account, 34
retained earnings, 147–148 Taxes payable, 98
stock dividends, 149–151 Tax loss recovery, 107–108
stock splits, 149–151 Time value of money, 111–113
treasury stock, 148–149 annuities, 116–122
annuity due, 119–122
Pacioli, Luca, 23 ordinary annuity, 119–122
Par value. See Face value of bond bond valuation, 122–126
Payables, 98 compounding, 111, 113–115
Payment date, 147 discounting, 111–115
Percentage of sales, 65–71 interest rate, periodic, 115–116
Preferred shares, 144–147 Treasury stock, 148–149
Premiums, 138–140
Present value (PV), 112–113 Wages payable, 98
Price value, 128
Prime rate, 97 Yield, 128
Profitability ratios, 178–180
Profit before tax, 56 Zero-coupon bonds, 135
OTHER TITLES IN OUR FINANCIAL ACCOUNTING
AND AUDITING COLLECTION
Mark S. Bettner, Bucknell University and
Michael P. Coyne, Fairfield University, Editors
• Executive Compensation: Accounting and Economic Issues by Gary Giroux

• Using Accounting and Financial Information: Analyzing, Forecasting, and
Decision-Making by Mark Bettner
• Pick a Number: Internationalizing U.S. Accounting by Roger Hussey and Audra Ong
• International Auditing Standards in the United States: Comparing and Understanding
Standards for ISA and PCAOB by Asokan Anandarajan and Gary Kleinman
• Accounting for People Who Think They Hate Accounting by Anurag Singal
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ACCOUNTING FOR FUN AND PROFIT

BY LIBRARIANS This book explains the fundamentals of financial state-

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ISBN-13: 978-1-63157-511-2 (paperback)

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Collection ISSN: 2151-2795 (print)

Cover and interior design by S4Carlisle Publishing Services

First edition: 2016

Printed in the United States of America.

The book takes the perspective of a user of financial information and

Accounting is about communication. It is an economic information

government and the general public.1 By contrast, private firms do not

• Owners, both current (those who actually own a piece or

In sum, senior management publishes annual reports for various users.

year, but it is what happens. Management can make different accounting

Exhibit 1.1 What firm produced these covers?

Exhibit 1.2 Boeing Annual Report covers 2012 to 2014

Exhibit 1.3 Apple Inc. Annual Report cover 2015

Inside an Annual Report

present an overview or summary, whereas the notes contain much more

In Which Order Should Annual Reports be Read?

How to Read this Book

The Bottom Line

Accounting is Not Economic

This chapter describes the underlying nature of accounting and illustrates

Assets = Liabilities + Equity

1. Inventory reported using the First-In First-Out method,

The Bottom Line

If the Auditors Sign Off,

Originally published on HBR.org Tuesday May 1, 2012, by Lawrence Weiss

The Accounting Process

The first step to learn about accounting is understanding the process of

Account—The Basic Unit of Storage

The Balance Sheet

Assets = Liabilities + Owners’ Equity1

Liabilities represent future economic sacrifices of goods (including

Assets − Liabilities = Owners’ Equity

Although this is mathematically correct, it does not reflect the un-

Debit to the Left, Credit to the Right

What is a debit and what is a credit? To an accountant, the word debit

But when is an account debited or credited? Excellent question. Assets

Note, an asset (cash) decreases, and another (cash in bank) increases.

The system is designed to limit mistakes by requiring, for each trans-

Assets = Liabilities + Owners’ Equity

The above may sound confusing, but to understand accounting, you

1. The Balance Sheet equation is Assets = Liabilities + Owners’ Equity.

There is no rational for why a debit increases an asset and a credit

$220,000 with a credit. Assets = $220,000 = owners’ equity and

The accountant would show these transactions in her journal by list-

(1) January 1, 2015 Cash $220,000

(2) January 2, 2015 Cash $200,000

(3) January 3, 2015 PP&E $310,000

(4) January 6, 2015 Firm orders 10,000 T-shirts for $6 each

(5) January 8, 2015 Inventory $ 60,000

Property, plant and equipment

Cash Inventory PP&E A/P LTD CC

Cash Inventory PP&E A/P LTD CC

The Income Statement

account. Thus, once a year, the retained earnings account is increased