Chapter 1 Businessand Investing rev

© Michael Gene Willoughby 2016

Chapter 1

Business and Investing

PROPOSITION TO PRODUCT

A business enterprise begins with an idea called a value proposition. A value

proposition is an arrangement that offers customers a product or service that can be

provided at a reasonable cost and delivered at an attractive price – a Win/Win for

business and consumer.

The Business Plan

A business plan describes how the subject firm’s value proposition will be

commercialized. The commercialization of the value proposition is called the firm’s

business model which describes how the product or service is created, priced,

marketed, and distributed.

Assets

To carry out a business plan, firms need assets – the useful things that firms

need to do business. Assets can be:

Monetary (cash, for example);

Real (called tangible assets) – plants, property, & equipment (“PP&E”)

including tenant improvements (“TI’s”), warehouses, storefronts, and signage;

Furniture, fixtures, & equipment (“FF&E”) including computers, printers,

copiers, and office furniture;

Rolling stock such as cars &, trucks;

Supplies and inventory, etc;

Human – skilled and trained personnel;

Intangible – legal rights & protections such as Licenses, Copyrights, Patents &

Trademarks, Rights‐of‐Way, and Leaseholds;

Standards & operating procedures, recipes & processes;

Created, constructed, and assembled things such as designs or a workforce;

plus software and in‐process R&D (IPR&D”).

FINANCE


To acquire assets, firms need cash. To raise cash, firms create financial capital –

stock and bonds. Stocks and Bonds are financial securities ‐ legal claims to future

cash flows – that are sold to investors. Cash raised from the sale of stocks & bonds to

investors is finances the acquisition of assets and creates obligations on the part of

the issuing firm.

This is a 3‐Step process:

Finance is the study of these exchanges, essentially the inter‐temporal

allocation of cash between those who want to consume today and those who are

willing, for a reward, to delay consumption until later. 1

Capitalism

Modern capitalism is an economic system based on “money” and the creation

of financial capital which mobilizes surplus purchasing power (peoples’ savings).

Business enterprises buy surplus purchasing power by issuing financial securities,

i.e. people’s savings are invested in business enterprises. This process is mainstream

macroeconomics in a nutshell. The transfer of personal savings to business

investment is what fuels economic growth.

Debt and Equity

Bonds are debt‐capital. When a firm sells a bond, it is borrowing money from

bond‐holders. Bond‐holders are creditors because they lend money.

1 Someone (I wish I could remember who) told me that finance is the act of passing money from one hand to another until it disappears. It’s not difficult to imagine this.

Receive “Cash”

Acquire

“Assets”

Sell “Securities”


Shares of stock are called equity capital because shareholders are the firm’s

owners.

Bond‐holders and share‐holders have a common interest in the success of the

firm but they each have different claims on the firm’s future cash flows. Firms pay

interest to bond‐holders and dividends to share‐holders. Firms must pay interest on a

pre‐determined schedule – monthly, quarterly, or annually – or suffer undesirable

consequences. Bond‐holders have a guaranteed return at a fixed rate established in

the bond’s covenants. Thus, we call bond‐holders fixed income investors. Interestingly,

firms are not required to pay dividends to shareholders. Some firms pay dividends

and some don’t. Dividends paid by firms depend on the firms’ success. This means

that dividend theory is one of the more complicated topics in finance.

Future cash flows from financial securities include:

1) Interest payments on loans;

2) Coupon payments on Bonds;

3) Dividend payments on Shares of stock;

4) The return of principal, the Face value of a Bond;

5) Capital gains, called price appreciation, on Shares of stock.

Purchasers of financial securities expect both a return “of” and a return on their

initial investment. Total returns, however, are not always positive. Investors don’t

know how well the firm and the investment in the firm will perform.2 This

uncertainty underpins the risky nature of financial securities. Financial reporting by

firms on their financial performance provides investors with information to help

assess the riskiness of their investments.

Stock & Bond Prices

Stocks and bonds trade in financial markets on the secondary exchanges, such as

the New York Stock Exchange, and their prices are reported daily. Stock and bond

prices provide market‐based information on the financial health of firms.

We find the market value of a firm‐ its market capitalization (“Market Cap” ‐ as

the number of shares of common stock outstanding X the market price of each share.

A second measure of a firm’s value is enterprise value (“EV”) which is Market Cap

2 There is an important distinction here: we find good firms with bad stocks and good stocks from bad firms. You can learn more about this in Management 183.


plus the firm’s Debt less its cash & Cash Equivalents such as Treasury Bills and

Notes.3

Investors continuously analyze the financial performance of firms and watch

security prices closely. Making thoughtful security purchases and selling securities in

advance of poor firm performance is how investment managers try to “beat the

market”. Accounting is one of the primary tools that investors use to make decisions

about what securities to buy and sell.

BANKING AND FINANCIAL MARKETS

Banks are financial intermediaries. Banks intermediate between those who

have extra money at the moment and those who need extra money at the moment.

Banks borrow and lend. A successful bank borrows at low interest rates and lends at

higher interest rates. Commercial banks borrow from you & me via the many

relatively small deposits we make and package these into loans. The difference

between the interest rate that banks pay depositors and the interest rate that banks

charge borrowers is called the Spread. An interesting question, one that you can

answer for yourself with a bit of research is – are commercial banks’ lending

operations profitable? The answer might surprise you.

When ready to raise cash, firms hire investment bankers who assist firms by

underwriting (buying and selling) a firm’s securities in the Capital Markets.

Investment banks are the middlemen in Capital & Financial Markets.

Large initial offerings are usually underwritten by a syndicate (a collection) of

banks. The lead underwriter is called the Bookrunner.

3 You can learn about market capitalization, enterprise value, stocks, bonds, and investment banking in Economics 173A, B and in Management 181, 183, 185.


A list of the top Bookrunners for 2015 is below.

2015 Investment Banking "Bookrunner" Ranking 1st half of 2015.

Bookrunner Value in $Billions Deals

1 J.P. Morgan $ 146 516 2 B. of A. Merrill Lynch $ 135 477 3 Citigroup $ 113 497 4 Morgan Stanley $ 107 425 5 Goldman Sachs $ 101 355 6 Barclays $ 89 316 7 Deutsche Bank $ 87 322 8 HSBC $ 80 381 9 Wells Fargo $ 69 235

10 Credit Suisse $ 64 193

$ 993 2,059

Total $1,984 5,776

There are hundreds of deals captured in the numbers above. Below is a list of

the largest of the deals last year. Most of these were public placements, i.e. publicly‐

traded securities.


Top 10 Deals of 2014 Issuer Value in $Billions Country

Medtronic Inc. $ 17.0 USA

Apple Inc. $ 12.0 USA

Oracle Corp $ 10.0 USA

Petrobras Global Finance BV $ 8.5 Brasil

Alibaba Group Holding Ltd $ 8.0 China

Cisco Systems Inc. $ 8.0 USA

Walgreens Boots Alliance Inc. $ 8.0 USA

Bank of America Corp $ 7.6 USA

Bayer US Finance LLC $ 7.0 Germany

Verizon Communications Inc. $ 6.5 USA

Once the initial issue (the “IPO”) of securities is sold to the public, investors

can re‐sell those securities (get back to cash). Wall Street was one of the early, and

now the best organized, capital & financial markets. In addition to New York, we

have well‐organized financial markets in London, Tokyo, Hong Kong, Shanghai,

Singapore, and Dubai. When functioning properly, these markets provide liquidity

for firms and investors.

Liquidity

The stock and bond exchanges, part of the bigger financial markets, give

securities liquidity. Liquidity describes how quickly an investor can sell a security at,

or close to, a “fair price”. Liquidity is the nature and purpose of markets in general –

i.e. a place to make transactions quickly and fairly.


Chapter 2

Financial Reporting & Financial Statements

Financial reporting is the final product of the financial process. The

deliverable is the annual report, as well as four, interim, or quarterly, reports. Publicly‐

traded companies publish an annual report, formally called the Form 10‐K

consisting of the four financial statements, a Management Discussion & Analysis

(“MD&A). plus footnotes and disclosures about firm’s accounting policies. Firms

also publish quarterly reports called the Form 10‐Q. All financial reports include

four financial statements:

1) The Statement of Earnings (“Income Statement”);

2) The Statement of Financial Position (“Balance Sheet”);

3) The Statement of Cash Flows (“SCF”); and

4) The Statement of Shareholder’s Equity.

Annual reports are available at any publicly‐traded firm’s homepage or on

any financial data webpage such as msnmoney.com.

The primary purpose of financial reports is to provide useful information to

investors, creditors, suppliers, and employees (collectively “stakeholders”). In

answering certain questions:

Is the firm profitable;

What assets does the firm own and how do these compare with its

liabilities;

What are the sources of the firm’s financial capital;

Is there cash flow from the firm’s primary business model;

What does the firm do with its cash;

Is the firm in a financial position to prosper in the future?

Comparisons

Comparability is the cornerstone of Generally Accepted Accounting

Principles (“GAAP”). Investors continuously weigh the merits of an investment in


one enterprise or another. For this reason there is substantial, but not perfect,

similarity in the format of financial statements and related reporting across firms,

even those in similar industries. However, one prominent feature of financial

reporting is the substantial amount year‐to‐year and quarter‐on‐quarter

quantitative comparisons by each firm.

The centerpiece of any Annual Report is the Management Discussion &

Analysis (“MD&A”). Here is one paragraph from Nordstrom’s MD&A in its 2014‐

15 annual report.

We considered 2014 a watershed year in our company history, with our successful entry into Canada, continued expansion of our Nordstrom Rack business through store growth, the launch of Nordstromrack.com and the acquisition of Trunk Club. Our performance in 2014 reflected continued progress in executing our customer strategy through investments to drive growth across channels. We achieved total net sales growth of 7.8%, adding nearly $1 billion to our top-line and delivering record sales and earnings per diluted share. Our financial position remains strong and this marked the sixth consecutive year we generated over $1 billion in cash flow from operations.

Nordstrom

Most of us are familiar with Nordstrom. The family‐owned, Seattle shoe

store turned luxury dry‐goods retailer that is the anchor of many American

shopping malls. Its fiscal year is February to January. Its Annual Report is

published about 45 days after the end of January. In the Appendix to this chapter,

you will find the financial statements from Nordstrom’s most recent S.E.C. filings.

We will review and discuss these during in‐class lectures. In the meanwhile, the

next pages will outline, the basic financial statements – the Balance Sheet and the

Income Statement.

THE BALANCE SHEET

The balance sheet reports what the firm owns and owes at a point in time, i.e.

at the end of each interim period and at the end of the firm’s fiscal year. The

balance sheet is organized around the fundamental accounting equation:

Assets = Liabilities + Equity

The Balance sheet is called the Statement of Financial Position because it

reports the firm’s financial position ‐ its financial obligations as well as the costs (or


carrying values) of all things that the firm owns or controls that originated from a

transaction.

Values on the balance sheet are not market values, they are book values. Book

values are the values that were initially recorded at cost based on a transaction less

any periodic accounting adjustments.1

Assets, Liabilities, and Equity

Assets represent probable future economic benefits. while Liabilities represent

highly certain future economic sacrifices. Equity is the difference between assets

and liabilities. Equity represents the Shareholders’ claims on the firm’s net assets.

Equity is sometimes called the net book value of the firm.

We can illustrate the basic geography of the balance sheet with a simple

shape that puts Assets on the LHS (“left hand side”) and Liabilities & Equity on the

RHS. We will use this graphic throughout Econ 4 to depict our balance sheets

during in‐class examples.

1 Accounting adjustments are one of the more challenging aspects of accrual accounting and something that you should be alert to.

Assets

Liabilities

Equity


We can consider the balance sheet from several perspectives:

1) Its fundamental form:


2) A RHS beak‐out:

Assets = Current Liabilities + Debt + Equity

3) A finance perspective, where we recognize that Debt & Equity are the

sources of financial capital, also known as invested capital.

Assets = Current Liabilities + Financial Capital

4) An economic perspective, where Assets are identified by their nature and

Liabilities & Equity by their market names:

Monetary & Real Capital = Current Liabilities + Bonds + Stock

+ Retained Earnings

These are equivalent expressions of the duality assumption which says that

everything that the firm owns must have a source. Liabilities and equity are

merely sources of the cash used (or claims issued) to purchase assets.

Note that assets include things, stuff, land, buildings, moveable objects, etc.,

and some paper. Liabilities and equity are only paper.

Assets

Firms acquire assets for the sole purpose of generating revenue, (“sales”).

Sales are the genesis of the earnings process ‐ the top‐line of the income statement.

Assets are classified as either current or non‐current/long‐lived. Current assets

represent benefits that ought to become cash within the next accounting period.

Current assets include cash, receivables (“ARs”), inventory, pre‐paid expenses

(“Pre‐Paids”), supplies, short‐term loans (“Notes”) to employees or related parties.


Cash, ARs, Notes, and Pre‐Paids are monetary assets; inventory and supplies are

non‐monetary assets.

Long‐lived assets provide benefits – help generate revenues – over many

future accounting periods. Long‐lived assets include tangible things – things that

we can see, feel, & touch ‐ such as furniture, fixtures, & equipment (“FF&E”) and

plant, property, & equipment (“PP&E”). In economics, we generalize these as real

assets/capital. Some long‐lived assets are intangible such as leases, trademarks,

patents, in‐process research & development (“IPR&D”).

Not all assets are reported on the balance sheet. Only “purchased” assets are

reported on the balance sheet. Once recorded on the balance sheet, they are called

book assets, meaning that they are “on the books”.

Created assets such as a good reputation (“Goodwill”), an assembled

workforce, knowledge‐based procedures, customer lists, menus & recipes, etc. are

not reported on the balance sheet because there was no transaction giving these

assets an independent, objective value.

Many intangible assets are created, some are purchased. One of the more

interesting problems in corporate finance is the valuation of intangible assets

(“intangibles”). Intangibles have become increasingly more important in business

and most are worth substantially more (or substantially less) than their cost. The

inherent complication here is that revenues – the measure of an assets value ‐

created by intangible assets are synergistic with other assets, including tangible and

monetary assets.

Liquidity

Assets are listed on the balance sheet in order of liquidity. Liquidity indicates

how quickly an asset can be sold – turned into cash at a price close to book value.

Thus, liquidity has two dimensions: time and value.

Cash

Cash is the most liquid asset. It is already cash. The book value of cash is

equal to its market value. Cash is the only such asset.

Only cash is cash. Cash is unique in that it represents pure liquidity and it

can play several useful roles in business. For example:


1) Cash can be a commodity ‐ retail companies need cash to make change

at the point‐of‐sale;

2) Cash is liquidity ‐ firms need cash to pay bills in a timely manner. Cash

is the primary means of making payments.

3) Cash is nourishment. Cash is required to sustain the firm’s fixed assets

through repair or replacement of deteriorating real capital as well as

to sustain inventories;

4) Cash is security and happiness – firms need cash to pay interest and

principal on loans and, in some cases, to pay dividends to keep

shareholders happy with their investment in the firm;

5) Cash is money capital – it can be used to invest or to expand, to fund

R&D, to exploit commercial opportunities, to pay‐down debt, reward

investors with dividends, or to discipline rivals.

The first four roles are necessary to maintain an ongoing business entity. The

later role refers to “free” or excess cash.

Liabilities

Liabilities are future obligations. All liabilities are paper and, with only few

exceptions, strictly monetary, meaning that they are legal obligations to pay cash to

someone at a future date. The subject firm’s liabilities would be recorded on the

Creditors’ balance sheet as monetary assets.

Current liabilities include customer advances (“Unearned Revenue” or

“Advances”), accounts payable (“Payables”), accrued expenses (“Accruals”),

dividends payable, and various other short‐term obligations.

Long‐term liabilities are generally interest‐bearing debt (“Loans”). Other

long‐term liabilities include pension obligations, and deferred income taxes.

Equity

Equity items represent shareholder’s claims, each type reflecting some form

of equity financing. Cash contributed by owners at start‐up and the cash received

from initial sales of the firm’s common stock are booked as paid‐in‐capital (“P‐in‐K”).

Profits not distributed (“paid”) to shareholders as dividends are called retained

earnings.


There are other types of equity, most commonly Preferred Stock. Treasury

Stock, listed as negative equity, reflects amounts paid to repurchase common stock

from the public. Repurchases are called stock buy‐backs and can be a sign of

confidence or desperation on the part management.

The important distinction between liabilities and equity is that equity claims

are “residual”, i.e. subordinated to liability claims. This means that creditors must

be paid interest on their loans before shareholders receive dividends on their

shares.

A Generic Balance Sheet

We can combine the three sections of the balance sheet in a generic side‐by‐

side format and illustrate it like this:


ASSETS LIABILITIES & EQUITY

Current Assets Current Liabilities

Cash

Receivables Advances

(Allowance for bad‐debt)

Inventory Payables

Pre‐paid Expenses Accrued Expenses

Supplies

Dividends payable

Long‐lived Assets Non‐current Liabilities

Tangible long‐lived assets Loans

(Accrued depreciation) Bonds

Intangible assets Pension obligations

Equity

Contributed capital

(Treasury stock)

Retained earnings

Total Assets = Total Liabilities & Equity

Capital

The term “capital” is used with various modifiers. Here is a short list:

TERM SHORT DEFINITION

Real Capital Tangible assets

Intellectual Capital Intangible assets, i.e. Know‐how.

Financial Capital All of the money invested in a firm for the long‐term.

Debt Capital Creditor’s money, i.e. Loans.

Equity Capital Shareholder’s claims: Stock & Retained earnings.

Invested Capital Long‐term Debt capital plus Equity capital.

Working Capital Current assets, excluding excess cash.

Net Working Capital Current assets minus current liabilities.

Interest-bearing Debt.

Trade Credit Current

Working Assets

Current Working Liabilities


Working Capital – Some Important Symmetry

Most current asset & liability accounts are working accounts – where there is

day‐to‐day activity. The management of working capital is a challenge for firms. In

fact, many “profitable” firms have fallen into bankruptcy due to working capital

mismanagement.

The working capital accounts are memorializations of short‐term claims and

short‐term obligations created in the day‐to‐day business‐of‐business. Firms don’t

always receive cash from customers at every transaction. Instead, firms grant and

receive credit. Working capital records the total amount of credit extended by firms

to their customers. In addition, firms may be required to hold inventory to meet

customer demand. Inventories are working capital and financing them requires

cash. To mitigate/manage inventory costs, firm may seek credit from their

suppliers, called Payables.

When we speak of “net” working capital, we are referring to current assets

minus current liabilities – the difference between what the firm owns and what it

owes in the short‐term. Owning more than one owes is usually a good thing, unless

owning things uses more cash than the firm needs for the current, interim,

accounting period.


The Working Capital Accounts

Current Assets Current Liabilities

Receivables

Advances

Inventory

Payables

Pre‐paid Expenses

Accrued Expenses

Supplies

Receivables & Customer Advances2

Firms grant credit to customers, i.e. they accept I.O.U.’s instead of cash from

customers. These are Receivables and they reflect a sale to a customer who

promises to pay later; Advances reflect customers paying in advance of the sale.

Receivables and advances are analogs of each other.

Inventory and Vendor Payables

Inventories are things held for sale to customers. Firms carry inventory in

order to satisfy customer demand. Financing inventory is costly, while not having

adequate inventory risks losing sales. This is a balancing act. Vendors help by

selling inventory to the firm on‐credit, called on‐Account. Firm’s report such credit

purchases as Payables.

Supplies

Supplies are things that the firm needs to do its business, not things for sale

to customers.

Pre‐paid Expenses and Accrued Expenses

In some instances, firms pay expenses in advance – called pre‐paid expenses

(“Pre‐Paids”). Sometimes, the firm pays expenses after employing the service – this

2 Customer Advances are also called Unearned Revenue and/or Deferred Revenue.


is called accruing the expense and this creates Accruals. Pre‐Paids and Accruals are

analogs of each other.

THE INCOME STATEMENT

The Income Statement reports the firm’s financial performance over an

accounting period. One might imagine two balance sheets – a beginning balance

sheet from the end of the prior period and an ending balance sheet for the current

period – as bookends on either side of the income statement.

The income statement reports flows – revenues & gains, i.e. inflows and

expenses & losses, i.e. outflows – from the firm’s business and the business of its

business.3 The top‐line is Sales and the bottom‐line is Net Earnings (“Profits”).

Revenue

Revenue is “sales”, customer purchases of goods & services.

The income statement reports the step‐by‐step quantitative details ‐ from the

top‐line to the bottom line. It outlines how reported profits are generated. This tour

makes sub‐total stops at various profit‐like measures such as:

Gross profit

EBITDA

EBIT aka Operating earnings

3 By business of its business, we mean that there are transactions that the firm conducts so that it can do business with its customers, transactions that are only tangential to the interactions with customers. I prefer to call these Back-Office activities.


Pre‐tax earnings

After‐tax income from continuing operations, and

the bottom line

Net Income – the firm’s “Earnings”

The most basic Income Statement is a single‐step format and looks like this:

Revenue

(Expenses)

Earnings

Revenue is the receipts of cash or claims‐to‐cash resulting from the firm’s

primary activities, i.e. the exercise of its value proposition. This probably seems

simple enough. However, with accrual accounting, the timing, as well as the

specific definition of sales revenue in many contexts, is not always obvious.

Interpretations and estimates go into this. In addition, firms may need to adjust

sales revenue for discounts, refunds, and returns.

The recognition of revenue is determined through the application of the

Realization Principle, one of the eight accrual accounting principles.4

Expenses

Moving from the single‐step format, more detail is reported by categorizing

“expenses”. For example, a two‐step format would look like this:

Revenue

less (Direct Expenses)

= Gross Profit

less (Operating Expenses)

= Operating Earnings

Firms typically expand this further, depending on:

a) the firm’s capital structure;

b) its business model;

c) manager’s preferences, and

4 The Realization Principle is the most important of the eight accrual principles, which we will study in Chapter 3.


d) auditor’s recommendations.

The interesting and challenging thing about the income statement is the

matter of categorizing expenses to better express when, and which costs are

incurred to generate profit.

Expenses are the costs of resources consumed to generate current revenue. It

takes money to make money; it takes expenses to generate revenue. Under accrual

accounting, expenses may be all, or just some, of the costs incurred by the firm to

generate revenue. The difference depends on timing, i.e. what resources (“costs”)

are consumed by period to generate revenues in that period.5

There are three types of expenses:

1) Direct expenses. Those costs that are directly associated with revenue,

such as: Cost‐of‐Goods Sold, Commissions, Returns, Warranties, and

Shipping.

2) Periodic expenses. Costs that are based on a period of time,

regardless of the level of revenue, for example: Rent, Salaries,

Insurance premiums, and Interest expense.

3) Indirect expenses. Other costs required carry‐out the sales process but that are neither directly related to sales nor periodic, for example:

utilities, telephone, travel, advertising, training, supplies.

In addition, there are a myriad of different kinds of expenses:

Operating versus Non‐operating expenses

Financing expenses 6

Recurring costs versus Non‐recurring costs

Expenses from discontinued operations

5 This is what the Matching Principle is all about. 6 Some firms are financed by borrowed money. Debt requires interest payments which are an expense.

Interest expense is a financing expense. The recognition of interest expense on the income statement is

given a separate line. Debt creates leverage, it enhances the return on investment. We say that a firm

that carries debt is a levered firm.


Operating expenses are related to the firm’s business model – its value

proposition and any related activities. Financing expenses are periodic borrowing

costs, i.e. interest paid on loans to creditors.7 Recurring costs are not related to the

firm’s business model but are related to the economic environment. Recurring costs

are not periodic but are expected. Non‐recurring costs are unusual, infrequent, and

unpredictable.

Gathering all of this together and laying‐it‐out in descending order from

operating, to non‐operating recurring and non‐recurring, then extraordinary, we

make a multi‐step income statement. This illustrates the types and categories of

expenses and the resulting levels (sub‐totals) of profit leading to the bottom line, net

income.8

(1) SALES. The top‐line.

less direct expenses, i.e. “COS” including “COGS”

(2) = GROSS PROFIT

less ”G&A” expenses – these are indirect & periodic expenses

(3) = EBITDA

less Depreciation and/or Amortization

(4) =EBIT, which is also known as (“aka”) Operating Earnings

less interest

plus Gains (Losses) from Recurring activities

(5) = EBT

less Taxes

+/‐ Infrequent or Unusual Items

(6) = INCOME FROM CONTINUING OPERATIONS

less Extraordinary items, which are Infrequent AND Unusual Items

(7) = NET INCOME. The bottom‐line.

This format illustrates the many ways that sales revenue can be absorbed by

the many types of expenses.

7 Dividends are paid to investors and are an outflow of cash, but dividends are not an expense.


Financial Comparisons

Comparability is the cornerstone of GAAP. Investors are continuously

weighing the merits of one investment versus another so it is important to have

information that is comparable both across firms and over periods of time. In most

cases, firms from similar industries tend to adopt similar accounting conventions

and interpret accounting principles in similar ways. The challenge for investors is

making comparisons between firms from different industries, with contrasting

business models, from different countries, are conglomerates, or amongst firms that

are uniquely, vertically integrated.

A simple and systematic way to compare performance across a collection of

companies is to “common‐size” their financial reports. Common‐sizing means

applying a common denominator to each of the financial statements. For example,

the investor can divide the reported sub‐totals from a multi‐step income statement

by Revenue. This is called common‐sizing the income statement. It yields a set of

ratios which we call the “Margins”, meaning the __________ Profit‐Margins. For

example, [net profit / revenue] = the Net Profit Margin (“NPM”) which indicates

how many cents “¢ “ out of every $1 in sales goes to investors after the firm pays all

of the costs of earning that dollar.

We can common‐size contrasting statements by using the respective firm’s

Sales as the common denominator. We did this for Nordstrom. Let’s add Walmart

to the mix and make a side‐by‐side comparison of the two companies on the next

page.

EBITDA

EBITDA is a popular, if occasionally controversial ‐ the WorldCom

meltdown was facilitated by naïve reliance on EBITDA ‐ number for evaluating a

firm’s earnings.

Before we examine EBITDA, we need to consider EBIT (Earnings Before

Interest and Taxes). EBIT is synonymous with Operating Income ‐ the profit or loss

that is generated by primary activities before interest expenses and taxes.

8 A Chart of Accounts is provided at the back of this Reader where you can review the variety of expense accounts that a typical firm might use.


EBITDA is a component of EBIT. EBITDA is Earnings Before Interest, Taxes,

Depreciation, and Amortization.

Depreciation and amortization are unique expenses. They are non‐cash

expenses related to long‐lived assets previously purchased. Second, they are

expenses that are subject to management’s estimates and judgments.

EBITDA is a number often used in the financial industry to evaluate

borrowing limits for firms. One of the most common methods to value small

businesses being acquired is by using multiples of EBITDA. For example an

enterprise that generates $1 million dollars of EBITDA in an industry where shares

of stock sell for 7 times EBITDA per share, the expected value of that enterprise will

likely be in the $7 million dollar range.

Bankers like EBITDA because it is a reasonable proxy for operating cash

flows (once non‐cash expenses are added‐back). However, EBITDA can be

misused. Waste Management revised its depreciation schedules on its rolling‐stock

(garbage trucks) from 5 years to 8 years. This reduced depreciation expense and

boosted profits. Some airlines did the same thing with costs for the Boeing 737.

WorldCom capitalized normal periodic expense and maintenance costs, shifting

expenses from SG&A, which would depress EBITDA to Depreciation, which left

EBITDA unaffected. Bankers lent WorldCom seemingly endless amounts of cash

trusting EBITDA to represent enough cash flow to repay the loans. A good analyst

won’t fall into the EBITDA trap if he/she compares to cash flow from operating

activities (“CFOA”) to insure that EBITDA does actually convert to cash as

expected.

Extracts from Nordstrom’s 2015‐16 Form 10K

Item 8. Financial Statements and Supplementary Data.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Nordstrom, Inc. Seattle, Washington

We have audited the accompanying consolidated balance sheets of Nordstrom, Inc. and subsidiaries (the “Company”) as of January 30,2016 and January 31, 2015, and the related consolidated statements of earnings, comprehensive earnings, shareholders’ equity, and cashflows for each of the three years in the period ended January 30, 2016. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Nordstrom, Inc. andsubsidiaries as of January 30, 2016 and January 31, 2015, and the results of their operations and their cash flows for each of the three yearsin the period ended January 30, 2016, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’sinternal control over financial reporting as of January 30, 2016, based on the criteria established in Internal Control-Integrated Framework(2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2016 expressedan unqualified opinion on the Company’s internal control over financial reporting.

/s/ Deloitte & Touche LLPSeattle, WashingtonMarch 14, 2016

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36

Nordstrom, Inc.Consolidated Statements of EarningsIn millions except per share amounts

Fiscal year 2015 2014 2013Net sales $14,095 $13,110 $12,166Credit card revenues, net 342 396 374Total revenues 14,437 13,506 12,540Cost of sales and related buying and occupancy costs (9,168) (8,406) (7,737)Selling, general and administrative expenses (4,168) (3,777) (3,453)Earnings before interest and income taxes 1,101 1,323 1,350Interest expense, net (125) (138) (161)Earnings before income taxes 976 1,185 1,189Income tax expense (376) (465) (455)Net earnings $600 $720 $734

Earnings per share:Basic $3.22 $3.79 $3.77Diluted $3.15 $3.72 $3.71

Weighted-average shares outstanding:Basic 186.3 190.0 194.5Diluted 190.1 193.6 197.7

The accompanying Notes to Consolidated Financial Statements are an integral part of these financial statements.

Nordstrom, Inc.Consolidated Statements of Comprehensive EarningsIn millions

Fiscal year 2015 2014 2013Net earnings $600 $720 $734Postretirement plan adjustments, net of tax of ($15), $7 and ($6) 24 (11) 10Foreign currency translation adjustment (18) (14) (2)Comprehensive net earnings $606 $695 $742


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Nordstrom, Inc. and subsidiaries 37

Nordstrom, Inc.Consolidated Balance SheetsIn millions

January 30, 2016 January 31, 2015AssetsCurrent assets:

Cash and cash equivalents $595 $827Accounts receivable, net 196 2,306Merchandise inventories 1,945 1,733Current deferred tax assets, net — 256Prepaid expenses and other 278 102

Total current assets 3,014 5,224

Land, property and equipment, net 3,735 3,340Goodwill 435 435Other assets 514 246Total assets $7,698 $9,245

Liabilities and Shareholders’ EquityCurrent liabilities:

Accounts payable $1,324 $1,328Accrued salaries, wages and related benefits 416 416Other current liabilities 1,161 1,048Current portion of long-term debt 10 8

Total current liabilities 2,911 2,800

Long-term debt, net 2,795 3,123Deferred property incentives, net 540 510Other liabilities 581 372

Commitments and contingencies (Note 12)

Shareholders’ equity:Common stock, no par value: 1,000 shares authorized; 173.5 and 190.1 shares issued and

outstanding 2,539 2,338(Accumulated deficit) Retained earnings (1,610) 166Accumulated other comprehensive loss (58) (64)

Total shareholders’ equity 871 2,440Total liabilities and shareholders’ equity $7,698 $9,245


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38

Nordstrom, Inc.Consolidated Statements of Shareholders’ EquityIn millions except per share amounts

Retained AccumulatedEarnings Other

Common Stock (Accumulated ComprehensiveShares Amount Deficit) Loss Total

Balance at February 2, 2013 197.0 $1,645 $315 ($47) $1,913Net earnings — — 734 — 734Other comprehensive earnings — — — 8 8Dividends ($1.20 per share) — — (234) — (234)Issuance of common stock under stock compensation plans 3.2 124 — — 124Stock-based compensation 0.1 58 — — 58Repurchase of common stock (9.1) — (523) — (523)Balance at February 1, 2014 191.2 1,827 292 (39) 2,080Net earnings — — 720 — 720Other comprehensive loss — — — (25) (25)Dividends ($1.32 per share) — — (251) — (251)Issuance of common stock for Trunk Club acquisition 3.7 280 — — 280Issuance of common stock under stock compensation plans 3.6 161 — — 161Stock-based compensation 0.5 70 — — 70Repurchase of common stock (8.9) — (595) — (595)Balance at January 31, 2015 190.1 2,338 166 (64) 2,440Net earnings — — 600 — 600Other comprehensive earnings — — — 6 6Dividends ($1.48 per share) — — (280) — (280)Special dividend related to the sale of credit card receivables($4.85 per share) — — (905) — (905)Issuance of common stock for Trunk Club acquisition 0.3 23 — — 23Issuance of common stock under stock compensation plans 2.0 108 — — 108Stock-based compensation 0.2 70 — — 70Repurchase of common stock (19.1) — (1,191) — (1,191)Balance at January 30, 2016 173.5 $2,539 ($1,610) ($58) $871


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Nordstrom, Inc. and subsidiaries 39

Nordstrom, Inc.Consolidated Statements of Cash FlowsIn millions

Fiscal year 2015 2014 2013Operating ActivitiesNet earnings $600 $720 $734Adjustments to reconcile net earnings to net cash provided by operating activities:

Depreciation and amortization expenses 576 508 454Amortization of deferred property incentives and other, net (79) (76) (58)Deferred income taxes, net 142 7 12Stock-based compensation expense 70 68 58Tax benefit from stock-based compensation 15 20 21Excess tax benefit from stock-based compensation (15) (22) (23)Bad debt expense 26 41 52Change in operating assets and liabilities:

Accounts receivable (56) (161) (93)Proceeds from sale of credit card receivables originated at Nordstrom 1,297 — —Merchandise inventories (203) (176) (157)Prepaid expenses and other assets (126) (4) (6)Accounts payable (2) 15 167Accrued salaries, wages and related benefits (2) 18 (12)Other current liabilities 50 155 60Deferred property incentives 156 110 89Other liabilities 2 (3) 22

Net cash provided by operating activities 2,451 1,220 1,320

Investing ActivitiesCapital expenditures (1,082) (861) (803)Change in credit card receivables originated at third parties 34 (8) (6)Proceeds from sale of credit card receivables originated at third parties 890 — —Other, net 14 (20) (13)

Net cash used in investing activities (144) (889) (822)

Financing ActivitiesProceeds from long-term borrowings, net of discounts 16 34 399Principal payments on long-term borrowings (8) (7) (407)Defeasance of long-term debt (339) — —Increase (decrease) in cash book overdrafts 23 (4) 47Cash dividends paid (1,185) (251) (234)Payments for repurchase of common stock (1,192) (610) (515)Proceeds from issuances under stock compensation plans 94 141 103Excess tax benefit from stock-based compensation 15 22 23Other, net 37 (23) (5)

Net cash used in financing activities (2,539) (698) (589)

Net decrease in cash and cash equivalents (232) (367) (91)Cash and cash equivalents at beginning of year 827 1,194 1,285Cash and cash equivalents at end of year $595 $827 $1,194

Supplemental Cash Flow InformationCash paid during the year for:

Income taxes, net of refunds $383 $391 $445Interest, net of capitalized interest 136 152 170

Non-cash investing and financing activities:Beneficial interest asset acquired from the sale of credit card receivables 62 — —Issuance of common stock for Trunk Club acquisition 23 280 —Debt exchange — — 201


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40

Extracts from Facebook’s Form 10Q

Quarterly Results of Operations Data

The following tables set forth our unaudited quarterly consolidated statements of operations data in dollars and as a percentage of total revenue for each of the eight quarters in the period ended December 31, 2012 . We have prepared the quarterly consolidated statements of operations data on a basis consistent with the audited consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. In the opinion of management, the financial information reflects all adjustments, consisting only of normal recurring adjustments, which we consider necessary for a fair presentation of this data. This information should be read in conjunction with the audited consolidated financial statements and related notes included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. The results of historical periods are not necessarily indicative of the results of operations for any future period.

Share-based compensation expense included in costs and expenses:

_____________________

52

Three Months Ended

Dec 31,

2012 Sep 30,

2012 Jun 30,

2012 Mar 31,

2012 Dec 31,

2011 Sep 30,

2011 Jun 30,

2011 Mar 31,

2011

(in millions)

Consolidated Statements of Operations Data:

Revenue:

Advertising revenue $ 1,329 $ 1,086 $ 992 $ 872 $ 943 $ 798 $ 776 $ 637

Payments and other fees revenue (1) 256 176 192 186 188 156 119 94

Total revenue 1,585 1,262 1,184 1,058 1,131 954 895 731

Costs and expenses:

Cost of revenue 398 322 367 277 247 236 210 167

Research and development 297 244 705 153 124 108 99 57

Marketing and sales 193 168 392 143 120 114 96 62

General and administrative 174 151 463 104 92 82 83 57

Total costs and expenses 1,062 885 1,927 677 583 540 488 343

Income (loss) from operations 523 377 (743 ) 381 548 414 407 388

Income (loss) before (provision for) benefit from income taxes 505 372 (765 ) 382 520 379 399 398

Net income (loss) $ 64 $ (59 ) $ (157 ) $ 205 $ 302 $ 227 $ 240 $ 233

Net income (loss) attributable to Class A and Class B common stockholders $ 64 $ (59 ) $ (157 ) $ 137 $ 205 $ 150 $ 159 $ 153

Earnings (loss) per share attributable to Class A and Class B common stockholders:

Basic $ 0.03 $ (0.02 ) $ (0.08 ) $ 0.10 $ 0.15 $ 0.11 $ 0.12 $ 0.12

Diluted $ 0.03 $ (0.02 ) $ (0.08 ) $ 0.09 $ 0.14 $ 0.10 $ 0.11 $ 0.11

Three Months Ended

Dec 31,

2012 Sep 30,

2012 Jun 30,

2012 Mar 31,

2012 Dec 31,

2011 Sep 30,

2011 Jun 30,

2011 Mar 31,

2011

(in millions)

Cost of revenue $ 9 $ 8 $ 66 $ 5 $ 3 $ 3 $ 3 $ —


Marketing and sales 27 28 232 19 13 13 11 —

General and administrative 24 29 263 19 18 21 15 3

Total share-based compensation expense (2) $ 184 $ 179 $ 1,106 $ 103 $ 76 $ 70 $ 64 $ 7

(1) In the fourth quarter of 2012, we recorded all Payments revenue at the time of purchase of the related virtual or digital goods, net of estimated refunds or chargebacks, instead of deferring Payment revenue until the expiration of the 30-day claim period, as we are able to estimate future refunds and chargebacks based on historical trends. This charge resulted in a one-time increase in Payment revenue of $66 million in the fourth quarter of 2012.

(2) In the second quarter of 2012, we recognized $986 million of share-based compensation expense related to Pre-2011 RSUs that vested in connection with our IPO.

Share-based compensation expense included in costs and expenses:

53

Three Months Ended

Dec 31,

2012 Sep 30,

2012 Jun 30,

2012 Mar 31,

2012 Dec 31,

2011 Sep 30,

2011 Jun 30,

2011 Mar 31,

2011

(as a percentage of total revenue)

Consolidated Statements of Operations Data:

Revenue:

Advertising revenue 84 % 86 % 84 % 82 % 83 % 84 % 87 % 87 %

Payments and other fees revenue 16 14 16 18 17 16 13 13

Total revenue 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 %

Costs and expenses:

Cost of revenue 25 26 31 26 22 25 23 23

Research and development 19 19 60 14 11 11 11 8 Marketing and sales 12 13 33 14 11 12 11 8 General and administrative 11 12 39 10 8 9 9 8

Total costs and expenses 67 70 163 64 52 57 55 47

Income (loss) from operations 33 30 (63) 36 48 43 45 53 Income (loss) before (provision for)

benefit from income taxes 32 29 (65) 36 46 40 45 54

Net income (loss) 4 % (5 )% (13)% 19 % 27 % 24 % 27 % 32 %

Net income (loss) attributable to Class A and Class B common stockholders 4 % (5 )% (13)% 13 % 18 % 16 % 18 % 21 %

Three Months Ended

Dec 31,

2012 Sep 30,

2012 Jun 30,

2012 Mar 31,

2012 Dec 31,

2011 Sep 30,

2011 Jun 30,

2011 Mar 31,

2011

(as a percentage of total revenue)

Cost of revenue 1 % 1% 6% — % — % — % — % — %


Marketing and sales 2 2 20 2 1 1 1 —

General and administrative 2 2 22 2 2 2 2 —

Total share-based compensation expense 12 % 14 % 93 % 10 % 7 % 7% 7 % 1 %

Liquidity and Capital Resources

Our principal sources of liquidity are our cash and cash equivalents, marketable securities, and cash generated from operations. Cash and cash equivalents and marketable securities consist primarily of cash on deposit with banks and investments in money market funds and U.S. government and U.S. government agency securities. Cash and cash equivalents and marketable securities totaled $9.63 billion as of December 31, 2012 , an increase of $5.72 billion from December 31, 2011 . The most significant cash flow activities consisted of $6.8 billion of net proceeds from our IPO, which was completed in May 2012, $1.61 billion of cash generated from operations, $1.5 billion of loan draw down and $1.03 billion in excess tax benefit from share-based award activity, offset by $2.86 billion of taxes paid related to the net share settlement of RSUs when the Pre-2011 RSUs vested and settled in the fourth quarter of 2012, $1.24 billion used for capital expenditures and $911 million used for acquisitions of businesses and other assets. If we continue to net settle RSUs, we will use additional cash to pay employees' tax withholding obligations in connection with such settlements. We currently anticipate that our available funds, credit facilities, and cash flow from operations will be sufficient to meet our operational cash needs for the foreseeable future.

In February 2012, we entered into an agreement for an unsecured five-year revolving credit facility that allows us to borrow up to $5 billion for general corporate purposes, with interest payable on the borrowed amounts set at London Interbank Offered Rate (LIBOR) plus 1.0% . Under the terms of the agreement, we are obligated to pay a commitment fee of 0.10% per annum on the daily undrawn balance. No amounts were drawn down under this credit facility as of December 31, 2012.

Concurrent with our entering into the revolving credit facility, we also entered into a bridge credit facility agreement that allowed us to borrow up to $3 billion to fund tax withholding and remittance obligations related to the settlement of RSUs in connection with our IPO.

In October 2012, we amended and restated our bridge credit facility, converting it to an unsecured term loan facility (Amended and Restated Term Loan) that allowed us to borrow up to $1.5 billion to fund tax withholding and remittance obligations related to the settlement of RSUs in connection with our IPO, with interest payable on the borrowed amounts set at LIBOR plus 1.0%. We paid origination fees at closing of the Amended and Restated Term Loan, which fees are being amortized over the term of the facility. We drew down the $1.5 billion of the Amended and Restated Term Loan in October 2012 and paid an upfront fee of 0.15% on the loan amount, which fee is being amortized over the remaining term of the facility. Any amounts outstanding will become due and payable on October 25, 2015.

In connection with the draw down of the Amended and Restated Term Loan, to hedge our exposure to interest rate fluctuation, we entered into an interest rate swap agreement. The net effect of this swap agreement is to convert the variable interest rate to a fixed interest rate of 1.46% . The interest rate swap has a maturity date of October 25, 2015.

As of December 31, 2012, our income tax refundable of $451 million reflects the expected refund from income tax loss carrybacks to 2010 and 2011. We expect to receive this refund in the first six months of 2013.

As of December 31, 2012 , $565 million of the $9.63 billion in cash and cash equivalents and marketable securities was held by our foreign subsidiaries. We have provided for the additional taxes that would be due if we repatriated these funds for use in our operations in the United States.

Cash Provided by Operating Activities

Cash flow from operating activities during 2012 primarily consisted of adjustments to net income for certain non-cash items such as share-based compensation expense of $1.57 billion and total depreciation and amortization of $649 million , partially offset by income tax refundable of $451 million . The cash flow from operating activities during 2012 compared to 2011 increased modestly

54

Year Ended December 31,

2012 2011 2010

(in millions)

Consolidated Statements of Cash Flows Data:

Net cash provided by operating activities $ 1,612 $ 1,549 $ 698

Net cash used in investing activities (7,024 ) (3,023 ) (324 )

Net cash provided by financing activities 6,283 1,198 781

Purchases of property and equipment (1,235 ) (606) (293 )

Depreciation and amortization 649 323 139

Share-based compensation 1,572 217 20

as the increases in adjustments for non-cash items as described above were offset by a reduction in net income of $947 million and an increase in income tax refundable.

Cash flow from operating activities during 2011 primarily resulted from net income of $1 billion , adjusted for certain non-cash items, including depreciation and amortization of $323 million , and share-based compensation expense of $217 million .

Cash flow from operating activities during 2010 primarily resulted from net income of $606 million , adjusted for certain non-cash items, including depreciation and amortization of $139 million and share-based compensation expense of $20 million , partially offset by cash consumed by working capital of $70 million.

Cash Used in Investing Activities

Cash used in investing activities during 2012 primarily resulted from $4.87 billion for the net purchase of marketable securities, $1.24 billion for capital expenditures related to the purchase of servers, networking equipment, storage infrastructure, and the construction of data centers as well as $911 million for acquisitions of businesses and other assets, such as patents. The increase in cash used in investing activities during 2012 compared to 2011 was mainly due to increases in the purchase of marketable securities, acquisitions of businesses and other assets, and capital expenditures.

Cash used in investing activities during 2011 primarily related to the use of approximately $2.4 billion for the net purchase of marketable securities. Our cash used in investing activities in 2011 also consisted of capital expenditures of $606 million related to the purchase of servers, networking equipment, storage infrastructure, and the construction of data centers.

Cash used in investing activities during 2010 primarily consisted of capital expenditures related to the purchases of property and equipment and the construction of data centers. Changes in restricted cash and deposits consumed $9 million of cash related to security deposits in support of real estate expansion in 2010. Acquisitions, net of cash acquired, also consumed $22 million of cash in 2010.

We anticipate making capital expenditures in 2013 of approximately $1.8 billion.

Cash Provided by Financing Activities

In May 2012, we received $6.8 billion in proceeds from our IPO, net of offering costs. Our financing activities have primarily consisted of equity issuances, lease financing, and debt financing. Net cash provided by financing activities was $6.28 billion and $1.2 billion , in 2012 and 2011 ,respectively, and included excess tax benefits from stock award activities of $1.03 billion and $433 million for the same periods, respectively. In 2012, our net cash provided by financing activities included the draw down of $1.5 billion from the Amended and Restated Term Loan. We did not have a loan draw down in 2011. In the fourth quarter of 2012, we paid $2.86 billion of taxes related to the net settlement of RSUs when the Pre-2011 RSUs were vested and settled.

In January 2011, we completed an offering of our Class A common stock to certain non-U.S. investors that generated $998 million in net proceeds. In December 2010, we completed an offering of our Class A common stock that generated $500 million in proceeds.

In March 2010, we entered into a credit facility with certain lenders. This facility allowed for the draw down of up to $250 million in unsecured senior loans. In April 2010, we drew down the full amount available under the facility, and in March 2011, we repaid the entire $250 million balance.

Off-Balance Sheet Arrangements

We did not have any off-balance sheet arrangements as of December 31, 2012 .

55

Extracts from Enron’s 1st Quarter 2000, 2001 Form 10Q

ENRON CORP/OR/

FORM 10-Q(Quarterly Report)

Filed 05/15/00 for the Period Ending 03/31/00

Address 1400 SMITH ST

HOUSTON, TX 77002-7369Telephone 7138536161

CIK 0001024401Symbol ECSPQ

SIC Code 6200 - Security & Commodity Brokers, Dealers, Exchanges & ServicesIndustry Misc. Financial Services

Sector FinancialFiscal Year 12/31

http://www.edgar-online.com© Copyright 2011, EDGAR Online, Inc. All Rights Reserved.

Distribution and use of this document restricted under EDGAR Online, Inc. Terms of Use.

PART I. FINANCIAL INFORMATIO N ITEM 1. FINANCIAL STATEMENTS ENRON CORP. AND SUBSIDIARIES CONSOLIDATED CONDENSED INCOME STA TEMENT (In Millions, Except Per Share Am ounts) (Unaudited) Three Months Ended March 31, 2000 1999 Revenues $13,145 $7,632 Costs and Expenses Cost of gas, electricity and other products 11,888 6,300 Operating expenses 747 670 Depreciation, depletion and amortization 172 215 Taxes, other than income taxes 66 62 12,873 7,247 Operating Income 272 385 Other Income and Deductions Equity in earnings of unconsolidated affiliates 264 68 Gains on sales of assets and investments 18 12 Other income, net 70 68 Income before Interest, Minority Interests and Income Taxes 624 533 Interest and Related Charges, net 161 175 Dividends on Company-Obligated Preferred Securities of Subsidiaries 18 19 Minority Interests 35 33 Income Taxes 72 53 Net Income Before Cumulative Effect of Accounting Changes 338 253 Cumulative Effect of Accounting Changes, net of tax - (131) Net Income 338 122 Preferred Stock Dividends 20 4 Earnings on Common Stock $ 318 $ 118 Earnings per Share of Common Stock Basic Before Cumulative Effect of Accounting Changes $ 0.44 $ 0.36 Cumulative Effect of Accounting Changes - (0.19) Basic Earnings per Share $ 0.44 $ 0.17 Diluted Before Cumulative Effect of Accounting Changes $ 0.40 $ 0.34 Cumulative Effect of Accounting Changes - (0.18) Diluted Earnings per Share $ 0.40 $ 0.16 Average Number of Common Shares Used in Computation Basic 723 683 Diluted 852 745 The accompanying notes are an integral part of thes e consolidated financial statements.

PART I. FINANCIAL INFORMATION - (Co ntinued) ITEM 1. FINANCIAL STATEMENTS - (Con tinued) ENRON CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Millions) (Unaudited) March 31, December 31, 2000 1999 ASSETS Current Assets Cash and cash equivalents $ 466 $ 288 Trade receivables (net of allowance for doubtful accounts of $35 and $40, respectively) 3,899 3,030 Other receivables 453 518 Assets from price risk management activities 3,139 2,205 Inventories 437 598 Other 939 616 Total Current Assets 9,333 7,255 Investments and Other Assets Investments in and advances to unconsolidated equity affiliates 6,020 5,036 Assets from price risk management activities 3,428 2,929 Goodwill 2,905 2,799 Other 5,101 4,681 Total Investments and Other Assets 17,454 15,445 Property, Plant and Equipment, at cost Natural gas transmission 6,935 6,948 Electric generation and distribution 3,640 3,552 Construction in progress 1,409 1,491 Oil and gas, successful efforts method 705 690 Other 1,323 1,231 14,012 13,912 Less accumulated depreciation, depletion and amortization 3,315 3,231 Property, Plant and Equipment, net 10,697 10,681 Total Assets $37,484 $33,381 The accompanying notes are an integral part of thes e consolidated financial statements.

PART I. FINANCIAL INFORMATION - (Co ntinued) ITEM 1. FINANCIAL STATEMENTS - (Con tinued) ENRON CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Millions) (Unaudited) March 31, December 31, 2000 1999 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable $ 2,914 $2,154 Liabilities from price risk management activities 2,697 1,836 Short-term debt 1,884 1,001 Other 1,695 1,768 Total Current Liabilities 9,190 6,759 Long-Term Debt 8,288 7,151 Deferred Credits and Other Liabilities Deferred income taxes 1,791 1,894 Liabilities from price risk management activities 3,510 2,990 Other 1,594 1,587 Total Deferred Credits and Other Liabilities 6,895 6,471 Minority Interests 1,872 2,430 Company-Obligated Preferred Securities of Subsidiaries 1,099 1,000 Shareholders' Equity Second preferred stock, cumulative, no par value 129 130 Manditorily Convertible Junior Preferred Stock, Series B, no par value 1,000 1,000 Common stock, no par value 7,041 6,637 Retained earnings 2,922 2,698 Accumulated other comprehensive income (756) (741) Common stock held in treasury (16) (49) Restricted stock and other (180) (105) Total Shareholders' Equity 10,140 9,570 Total Liabilities and Shareholders' Equity $37,484 $33,381 The accompanying notes are an integral part of thes e consolidated financial statements.

PART I. FINANCIAL INFORMATION - (Co ntinued) ITEM 1. FINANCIAL STATEMENTS - (Con tinued) ENRON CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH F LOWS (In Millions) (Unaudited) Three Months Ended March 31, 2000 1999 Cash Flows From Operating Activities Reconciliation of net income to net cash provided by (used in) operating activities Net income $ 338 $ 122 Cumulative effect of accounting changes, net of t ax - 131 Depreciation, depletion and amortization 172 215 Deferred income taxes 30 2 Equity in earnings of unconsolidated affiliates (264) (68) Gains on sales of assets and investments (18) (12) Changes in components of working capital (313) (556) Net assets from price risk management activities (52) (518) Merchant assets and investments: Realized gains on sales (31) (22) Proceeds from sales 199 26 Additions and unrealized gains (517) (135) Other operating activities (1) 155 Net Cash Used in Operating Activities (457) (660) Cash Flows From Investing Activities Capital expenditures (496) (519) Equity investments (316) (409) Proceeds from sales of investments and other asse ts 17 43 Acquisition of subsidiary stock (619) - Business acquisitions, net of cash acquired (10) (38) Other investing activities (69) (207) Net Cash Used in Investing Activities (1,493) (1,130) Cash Flows From Financing Activities Issuance of long-term debt 1,361 114 Repayment of long-term debt (393) (68) Net increase in short-term borrowings 962 1,119 Issuance of common stock 179 839 Issuance of preferred securities of subsidiaries 105 - Dividends paid (156) (113) Net disposition of treasury stock 70 119 Other financing activities - (35) Net Cash Provided by Financing Activities 2,128 1,975 Increase in Cash and Cash Equivalents 178 185 Cash and Cash Equivalents, Beginning of Period 288 111 Cash and Cash Equivalents, End of Period $ 466 $ 296 Changes in Components of Working Capital Receivables $ (824) $ (549) Inventories 156 56 Payables 732 159 Other (377) (222) Total $ (313) $ (556) The accompanying notes are an integral part of thes e consolidated financial statements.

ENRON CORP/OR/

FORM 10-Q(Quarterly Report)

Filed 05/15/01 for the Period Ending 03/31/01

Address 1400 SMITH ST

HOUSTON, TX 77002-7369Telephone 7138536161

CIK 0001024401Symbol ECSPQ

SIC Code 6200 - Security & Commodity Brokers, Dealers, Exchanges & ServicesIndustry Misc. Financial Services

Sector FinancialFiscal Year 12/31

http://www.edgar-online.com© Copyright 2011, EDGAR Online, Inc. All Rights Reserved.

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PART I. FINANCIAL INFORMATIO N ITEM 1. FINANCIAL STATEMENTS ENRON CORP. AND SUBSIDIARIES CONSOLIDATED CONDENSED INCOME STA TEMENT (In Millions, Except Per Share Am ounts) (Unaudited) Three Months Ended March 31, 2001 2000 Revenues $50,129 $13,145 Costs and Expenses Cost of gas, electricity and other products 48,159 11,888 Operating expenses 993 747 Depreciation, depletion and amortization 213 172 Taxes, other than income taxes 88 66 49,453 12,873 Operating Income 676 272 Other Income and Deductions Equity in earnings of unconsolidated equity affiliates 74 264 Gains on sales of non-merchant assets 32 18 Other income, net 13 70 Income before Interest, Minority Interests and Income Taxes 795 624 Interest and Related Charges, net 201 161 Dividends on Company-Obligated Preferred Securities of Subsidiaries 18 18 Minority Interests 40 35 Income Taxes 130 72 Net Income Before Cumulative Effect of Accounting Changes 406 338 Cumulative Effect of Accounting Changes, net of tax 19 - Net Income 425 338 Preferred Stock Dividends 20 20 Earnings on Common Stock $ 405 $ 318 Earnings per Share of Common Stock Basic Before Cumulative Effect of Accounting Changes $ 0.51 $ 0.44 Cumulative Effect of Accounting Changes 0.03 - Basic Earnings per Share $ 0.54 $ 0.44 Diluted Before Cumulative Effect of Accounting Changes $ 0.47 $ 0.40 Cumulative Effect of Accounting Changes 0.02 - Diluted Earnings per Share $ 0.49 $ 0.40 Average Number of Common Shares Used in Computation Basic 752 723 Diluted 872 852 The accompanying notes are an integral part of thes e consolidated financial statements.

PART I. FINANCIAL INFORMATION - (Co ntinued) ITEM 1. FINANCIAL STATEMENTS - (Con tinued) ENRON CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Millions) (Unaudited) March 31, December 31, 2001 2000 ASSETS Current Assets Cash and cash equivalents $ 1,086 $ 1,374 Trade receivables (net of allowance for doubtful accounts of $416 and $133, respectively) 8,949 10,396 Other receivables 2,361 1,874 Assets from price risk management activities 12,672 12,018 Inventories 650 953 Deposits 2,349 2,433 Other 1,100 1,333 Total Current Assets 29,167 30,381 Investments and Other Assets Investments in and advances to unconsolidated equity affiliates 5,694 5,294 Assets from price risk management activities 9,998 8,988 Goodwill 3,609 3,638 Other 7,217 5,459 Total Investments and Other Assets 26,518 23,379 Property, Plant and Equipment, at cost Natural gas transmission 6,987 6,916 Electric generation and distribution 4,518 4,766 Fiber-optic network and equipment 912 839 Construction in progress 696 682 Other 2,184 2,256 15,297 15,459 Less accumulated depreciation, depletion and amortization 3,722 3,716 Property, Plant and Equipment, net 11,575 11,743 Total Assets $67,260 $65,503 The accompanying notes are an integral part of thes e consolidated financial statements.

PART I. FINANCIAL INFORMATION - (Co ntinued) ITEM 1. FINANCIAL STATEMENTS - (Con tinued) ENRON CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Millions) (Unaudited) March 31, December 31, 2001 2000 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable $ 8,686 $ 9,777 Liabilities from price risk management activities 10,840 10,495 Short-term debt 2,159 1,679 Customers' deposits 3,495 4,277 Other 2,390 2,178 Total Current Liabilities 27,570 28,406 Long-Term Debt 9,763 8,550 Deferred Credits and Other Liabilities Deferred income taxes 1,625 1,644 Liabilities from price risk management activities 10,472 9,423 Other 2,781 2,692 Total Deferred Credits and Other Liabilities 14,878 13,759 Minority Interests 2,418 2,414 Company-Obligated Preferred Securities of Subsidiaries 904 904 Shareholders' Equity Second preferred stock, cumulative, no par value 121 124 Mandatorily Convertible Junior Preferred Stock, Series B, no par value 1,000 1,000 Common stock, no par value 9,513 8,348 Retained earnings 3,525 3,226 Accumulated other comprehensive income (1,193) (1,048) Common stock held in treasury (1,082) (32) Restricted stock and other (157) (148) Total Shareholders' Equity 11,727 11,470 Total Liabilities and Shareholders' Equity $67,260 $65,503 The accompanying notes are an integral part of thes e consolidated financial statements.

PART I. FINANCIAL INFORMATION - (Co ntinued) ITEM 1. FINANCIAL STATEMENTS - (Con tinued) ENRON CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH F LOWS (In Millions) (Unaudited) Three Months Ended March 31, 2001 2000 Cash Flows From Operating Activities Reconciliation of net income to net cash used in operating activities Net income $ 425 $ 338 Cumulative effect of accounting changes, net of tax (19) - Depreciation, depletion and amortization 213 172 Deferred income taxes 113 30 Gains on sales of non-merchant assets (32) (18) Changes in components of working capital (599) (313) Net assets from price risk management activities (270) (52) Merchant assets and investments: Realized gains on sales 26 (31) Proceeds from sales 135 199 Additions and unrealized gains (74) (517) Other operating activities (382) (265) Net Cash Used in Operating Activities (464) (457) Cash Flows From Investing Activities Capital expenditures (382) (496) Equity investments (716) (316) Proceeds from sales of non-merchant investments 339 17 Acquisition of subsidiary stock - (485) Business acquisitions, net of cash acquired (33) (144) Other investing activities (332) (69) Net Cash Used in Investing Activities (1,124) (1,493) Cash Flows From Financing Activities Issuance of long-term debt 1,747 1,361 Repayment of long-term debt (996) (393) Net increase in short-term borrowings 799 962 Issuance of common stock 119 179 Issuance of preferred securities of subsidiaries - 105 Dividends paid (143) (156) Net (acquisition) disposition of treasury stock (226) 70 Net Cash Provided by Financing Activities 1,300 2,128 Increase in Cash and Cash Equivalents (288) 178 Cash and Cash Equivalents, Beginning of Period 1,374 288 Cash and Cash Equivalents, End of Period $ 1,086 $ 466 Changes in Components of Working Capital Receivables $ 627 $ (824) Inventories 169 156 Payables (1,062) 732 Other (333) (377) Total $ (599) $ (313) The accompanying notes are an integral part of thes e consolidated financial statements.

Chapter 3

Accrual Accounting & the Conceptual Foundations

In this chapter, we study accrual accounting and its conceptual foundations.

Accrual accounting is a principles‐based, as opposed to rules‐based, system for

capturing and reporting business activity and financial performance. It is based on

certain assumptions & principles, elements, terminology, and processes that are

designed to provide useful information to the investing public.

Terminology

Financial accounting is a professional art and it has its own terms of art ‐

words that have specific meanings, not necessarily the meanings that you might

expect. Learning accounting is an exercise in terminology and taxonomy –

definitions and structure. There is significant symmetry and supporting logic that

are not immediately intuitive, but become so, revealing a cohesive, internal logic,

much like a sophisticated card game.

Accounting is an Information System

At its core, financial accounting is a highly stylized system for gathering,

measuring, classifying, processing, and reporting selected information. Like all

information systems, there is a raw material ‐ some target information of particular

interest to a particular audience (in our case this audience is investors and

creditors). The target is a singular business enterprise and its transactions with

independent, unrelated parties, i.e. other firms and/or individuals.

Financial accounting involves formal steps:

i. Estimates

ii. Techniques

iii. Routines

iv. Adjustments

v. Periodic checks & controls

vi. Discussions & interpretations, and

vii. Choices.

This determines the end product of financial accounting, the firm’s financial

report – its financial statements and related disclosures.

All information systems generally follow four fundamental steps, and

financial accounting is fundamentally no different. The steps include:

(1) Collection

(2) Measurement (including estimates)

(3) Classification (a taxonomy), and

(4) Presentation – of the results in a stylized manner.

For any information system, we collect a common group of things, activities,

or phenomena. Next, we measure, classify, and organize them. Lastly, we put them

in a simple, friendly, format. This is similar to how we handle our cell phone’s

contacts list, or our LinkedIn accounts, or our Facebook account:

We collect information about people

We measure and classify the information (and the people, as well) in

various ways that suit our interpretations of them – we give them

labels.

We manipulate the information to fit our intentions and objectives

within the context of our association with them – socially, this means

professional, friendly, romantic, competitive, etc.

The Role of Estimates

Measurements and estimates play a significant role in financial accounting.

Businesses enterprises are unique organizations and commercial activity can be

complex. Measuring is not as simple as it might seem. There is, therefore, a need

for estimates which introduce interpretations.

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Consider Nordstrom’s description of the role of in its Quarterly financial

reports:

The preparation of our financial statements requires management to make

estimates and assumptions that affect the reported amounts of assets,

liabilities, revenues and expenses, and disclosure of contingent assets and

liabilities. We base our estimates on historical experience and other

assumptions that we believe to be reasonable under the circumstances.

Actual results may differ from these estimates and assumptions.

Financial Accounting

In Economics 4 at UCSD we study financial accounting, separately from cost

or managerial accounting. Financial accounting is the language of modern

business. It is based on a systematic process of counting and recording the cost and

use of assets to generate sales and profits by a single business entity (the “firm”).

There are two, distinct methods of financial accounting:

Cash‐basis (most often applied as modified Cash‐basis); and

Accrual Accounting

Each has a fundamentally distinct way of looking at commercial activity and

reporting financial performance.

Cash‐basis Accounting

Cash is critically important in business, yet it plays a supporting, not a

primary, role in accrual accounting.

Cash‐basis records only exchanges of cash. For purposes of income tax,

individuals use cash‐basis accounting, as do most small businesses.

Cash‐basis accounting is rules‐based. “The rule is: if cash is exchanged record

it; if not, then don’t. Interpretations, estimates, and promises don’t count. This

makes it objective and factual. “Only cash is cash”. Moreover it implies, “no cash,

no activity”. Ambiguity can be introduced in the cash‐basis accounting process by

the timing of cash receipts or disbursements which can be manipulated. Firms on

either side of a transaction may delay or accelerate cash payments.

In addition to this timing issue, cash‐basis accounting also ignores the nature

of the underlying activity that gave rise to the cash exchange. Receiving cash from

the sale of goods or services is treated the same as refunding a deposit.

Accrual Accounting

Accrual accounting is much broader than cash‐basis accounting and when

we speak of financial accounting, we generally mean accrual accounting.

The focus of accrual accounting is on earnings and, unfortunately, earnings

are often challenging to measure. Truly reasonable accounting is subtle.

Complications arise because business practices are constantly evolving, becoming

more complicated. Moreover, transactions are seldom simple. Furthermore, the

financial effects of certain transactions persist over long periods of time, so their

effects can’t be completely captured in one accounting period. The primary

objective of financial accounting is to provide useful information about the firm’s

past and prospective earnings, i.e. its profits. Profits reported using accrual

accounting are a “construct”, something that results from a myriad of

measurements, estimates, interpretations, judgments, and classifications of business

activity.

Accrual accounting is guided by the accrual concept. The primary objective of

accounting is to provide useful information about the firm’s past and prospective

earnings. To be useful for this purpose, firms must record inflows of cash and

claims to cash matched against their respective, and necessary, outflows of cash and

claims to cash. Earnings are rewards minus sacrifices, i.e. net rewards. And

rewards are not rewards unless the effort to achieve rewards is complete, finished.

Accrual accounting is principles‐based. Accrual’s principles are reflected in a

collection of standards – Statements of Financial Accounting Standards (”SFAS”

also called the “Standards”) – promulgated by the Financial Accounting Standards

Board (“FASB”) a non‐government organization (“NGO”). The Statements, along

with related guidance, are called G.A.A.P. – Generally Accepted Accounting

Principles – and represent the foundation of accrual accounting and financial

reporting in the United States.

Accrual requires that transactions be recorded when things happen,

regardless of whether cash plays a role at that moment. Accrual principles require

that firms record transactions that reflect the earnings process. Revenue and/or

income is recorded when it is earned and expenses are recorded when incurred. This

means that accrual accounting profits are reported with or without associated cash

flows.

Accrual accounting principles help guide interpretations of commercial

activities. Managers make judgments. To a large extent, managers decide what

matters and what does not, as well as when something matters. Measurements are

made and, often, estimates are required. Subjectivity and questions of

reasonableness enter the accounting process when principles, rather than rules, are

applied. This means that variations arise in how events are assessed and

conclusions drawn from a fixed collection of events may also vary. In other words,

under accrual accounting, more than one conclusion might reasonably result from a

single set of facts. 1

1 This paragraph is the motivation for the style and tone of this Reader.

Accounting concepts are a combination of assumptions and principles.

Assumptions set boundary conditions for discussion and reporting purposes. They

tell managers what’s in and what’s not. Assumptions narrow the focus of the

process and suggest what’s important and when it’s important. Assumptions

establish starting and stopping points.2

Accounting principles are guidelines, not rules per se. They suggest what is

acceptable (useful) and in what context. Principles mandate some, but not all,

aspects of financial reporting. Firms are allowed a degree of discretion. Principles

allow accounting standards to adapt in order to reflect changes in commercial

practices.3

Accrual Accounting Assumptions

There are five accounting assumptions:

1) The Entity assumption. A business is separate from its owners or other

businesses;

2) The Going Concern assumption. The subject firm will operate indefinitely.

Separate accounting treatment is applied when the firm, or some part of it, is

expected to cease;4

3) The Monetary Unit assumption. Transactions will be quantified in nominal

dollars, or other stable currency, unadjusted for inflation; and

4) The Period assumption. Business activities will be reported over specific

periods: one‐year, called the fiscal year, and four interim periods, called

quarters. A company’s fiscal year (“FY”) can start on or about the 1st day of

any month, and end on or about the 30th or 31st day twelve months later.

5) The Duality assumption. Any transaction or adjustment will affect at least

two accounts. This preserves the fundamental accounting equality:


2 Many people confuse “assumption” with “presumption”. Assume implies that something is true, withoutproof. Presume suggests that something is true on the basis of probability. For example, assuming that you like sports, I could presume that you would enjoy some baseball tickets. 3 http://www.investopedia.com/terms/a/accrualaccounting.asp.4 When a firm decides to discontinue a portion of its operations, the accounting for those operations isseparated from the accounting for the “ongoing” operations. Something similar is the case when a firm files for bankruptcy protection.

Accrual Accounting Principles

These are the eight accrual accounting principles:

1) The Cost Principle. The business will report amounts based on acquisition

costs, rather than at fair market value (“FMV”), with only selective

exceptions.

2) The Realization Principle (sometimes called the Revenue Principle). The

business will report revenue only when realized, i.e. when activities related

to selling goods or services are complete and cash collection is reasonably

likely.

3) The Matching Principle. Expenses should be “matched” with revenues.

This provides a timely connection between sacrifices and rewards in order

to better reflect a business’ profitability.

4) The Disclosure Principle. This principle recognizes that not all information

relevant to financial decision‐making is quantitative. Some important

information is narrative.

5) The Objectivity Principle. Reported information should be based on

objective evidence. The results of actual transactions with other entities are

the preferred basis for objectivity because it lends independence to the

evidence.

6) The Materiality Principle. The relative size and significance of reportable

items determine how it will be reported. For example, small transactions

are usually aggregated and reported together with other small transactions.

7) The Consistency Principle. Business should apply the same accounting

choices and methods year after year.

8) The Principle of Conservatism. Accountants should avoid exaggerations.

When making estimates and choosing between alternative interpretations of

facts, accounts should be reasonable and cautious.

Principles #2 and #3 are generally acknowledged as the forming the heart of

accrual accounting. This may explain why they are also the most abused of the

eight principles.

Revenue Recognition

When does a sales‐like activity create a sale, i.e. when is an inflow “earned”,

as opposed to simply received? The realization principle says that revenue is

“earned” when the risk of ownership of the product or service has been passed to

the customer and the firm has been paid or has a reasonable expectation of being

paid in the future.

To “earn” the price of its products, the firm must:

1) The seller must have deliver the product;

2) Both seller and buyer know the price, negotiations have ended; and

3) The seller has the cash or a legal claim to cash, or a

4) Reasonable expectation of collecting cash in the near future.

Buyers may pay for products (a) prior to delivery, (b) at the point‐of‐sale

“POS”), or (c ) or after receipt of the product. This means that, as long as delivery

has occurred, revenue can be essentially be recognized and reported. Accrual

frames the earnings process separately from exchanges of cash.

There are four possible combinations of earning (or not) and getting paid (or

not), that can be illustrated in a 2x2 matrix illustrating the intersections of delivery

(of goods) with cash (received).

Is the Good/Service Delivered to the Customer?

Yes No

a

Revenue not realized; because it has not been earned. An Advance is recorded

No delivery, no cash – nothing happened, nothing recorded.

Revenue realized and recognized.

Revenue realized and recognized. and a

Receivable recorded

Customer pays cash now.

Customer pays cash later.

Let’s consider two, common, commercial marketing situations:

a) Gift Cards; and

b) Frequent Flyer Miles.

These are examples of customers paying in advance of delivery of the

primary product, which would most likely be used in a future accounting period.

The “earnings process” is not complete until the card is used or the miles are

applied towards a flight. According to the realization principle, a firm cannot

recognize revenue untl it has been “realized” the sales process, i.e. delivered the

product to the customer. revenue. The realization principle mandates realization

before recognition.

Net Earnings

The profit story is not complete without the recognition of Expenses. The

matching principle guides the recognition of expenses.

Expenses are outflows, or sacrifices, that consumed in the pursuit of revenue.

At the back of this Reader, you will find a Chart of Accounts which lists all most of

the accounts representing “types” of each of the elements of accounting. Expenses

comprise the greatest number of types of elements.

In order to properly understand expense, we need to address costs.

Costs and Benefits

Cost is an especially important concept in accounting. A great deal of

accounting work, and some of the most thoughtful debates, involve the:

a) Classification of costs

b) Adjustments to costs

c) The allocation of costs “to” specific accounting periods or

“over” many accounting periods, and

d) The rationalization of costs to different events or entities.

Costs represent benefits. What firms (you & I, as well) pay for something

ought to reflect the benefits expected from it. In business, the expected “benefits” to

be derived from costs are Sales, i.e. revenue resulting from what was purchased.

A cost must initially be classified as either an asset or an expense. Managers

decide which it will be. If the benefits expected from the cost are likely to persist for

several, or many, future periods, then the cost is booked as a long‐lived asset (“LLA”

) and portions of that cost are expensed over the future accounting periods during

which the asset benefits revenue generation. Conversely, if the benefits expected

from the cost are only temporary, then the entire cost should be booked as an

expense in the current accounting period.

When managers decide what to do with a cost; they have two choices:

1) Expense the cost if it will benefit the firm now, but probably not later

as well; or

2) Capitalize the cost if it will benefit the firm now and later.

Expenses

The Matching Principle guides expense recognition. It requires that expenses

be “matched” with the recognition of revenue or the period in which expenses are

incurred. There are three types of expenses ‐ direct, indirect, and periodic ‐ plus

three categories of expenses – operating, non‐operating, and financing. In addition,

there are two types of costs that may appear on the Income Statement acting the

role of expenses. These are:

1) Recurring costs: neither operating nor periodic but expected;

2) Non‐recurring costs: non‐operating costs that are unusual or

infrequent.5

There is an important outflow of cash, called Dividends, that is not an

expense. Dividends are a return‐on‐investment (“ROI”) to the firm’s investors, its

shareholders.

Expensing (versus Capitalizing) Costs

All costs must be classified as expenses or capitalized (booked as long‐lived

assets) and expensed incrementally over future accounting periods, meaning to

apportion a large cost over many accounting periods.

If a cost is associated with something that will provide long‐term benefits

then the cost should be capitalized. Over time, benefits diminish, i.e. benefits expire.

Thus, the benefits of a long‐lived asset, represented by its capitalized cost, diminish

over time. As benefits are used, the cost must be expensed. “Expensing” implies

the matching of the expiration of the benefits of an asset with the revenues

generated by the asset. The allocation of the costs of long‐lived assets to future

5 Recently the FASB dropped “Extraordinary Items”, which were those costs that were both unusual and infrequent.

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