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MidtermReview

15.501/516AccountingSpring2004

ProfessorS.RoychowdhurySloanSchoolofManagement

MassachusettsInstituteofTechnology

Mar8,2004

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ExamStructure

z Ques1:

Tabular analysis of the effects of varioustransactionsonthebalancesheetequation

z Ques2:

Revenuerecognitionandaccountsreceivablesz Ques3

Inventories

z Ques4Cashflowfromoperations

z Expecttobetestedonanythingdiscussedinclass

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BalanceSheetEquation:

Assets=Liabilities+OwnersEquity

zAssets=probablefutureeconomicbenefitsownedbythefirm

z Liabilities=probablefutureeconomicsacrifices

z OwnersEquity =AssetsLiabilitiesownersclaim = own owez (OwnersEquityissometimesalsocalled

shareholdersequity,netbookvalue,ortheresidualclaim)

zAssets=Liabilities+Ownersequity3

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ChangesinShareholders

Equity

Beginningofyear: S.E.

PaidinCapital

RetainedEarnings

-

Beginning

Beginning

Ending

RetainedEarnings

+NetIncome+newpaidincapitalDividends

EndingPaidinCapital

Endofyear: S.E.4

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BalanceSheetEquation

zAssets=Liabilities+OwnersEquity

z Key:Everyeconomiceventthatleadstoanaccountingentryhastwosides

z Givenaneventandanaccountingentry,youshouldbeabletoidentifythetwosides

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Contra-AssetAccounts

z Contraassetaccountsactlikeliabilityaccountsincreasesare

recordedascreditsz

Theirexistenceistiedtospecificassetaccounts

z Forexample

z AllowanceforDoubtfulAccounts(existencetiedtoAccounts

Receivables,acurrentasset)z

AccumulatedDepreciation(existencetiedtodepreciablelong-termassetslikePP&E)

z Onthebalancesheet,AccountsReceivablesisreportednetofADA

andPP&EisreportednetofAccumulatedDepreciationz

Thus,contra-assetbalancesarenotreportedontheliabilitiesside,butasnegativenumbersontheassetside

z

AssetsContra-Assets(ifany)=Liabilities+StockholdersEquity

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DebitsandCredits

zAssets=Liabilities+OwnersEquity

z Increasesinassetsaredebits

z Increasesinliabilitiesarecredits

z IncreasesinOwnersEquity(CapitalStock,RE)arecredits

z RevenuesincreaseRetainedEarnings

Credits

z ExpensesreduceRetainedEarnings- Debits

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AccountingEntries

z Every accounting entry has two sides adebitandacredit.This is thesamepointastwoslidesbefore

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AccountingEntries

z Twokinds:z

Transactionsbasedz Adjustingentries

z

Transactions-based entries record the effects ofspecifictransactions

zAdjusting entries are entries that arise out of thebasicprinciplesofaccrualaccountingz Depreciationexpense

z Salariesexpenseevenwhenemployeeshavenotactually

beenpaid

z Baddebtexpense

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BasicPrinciplesofAccrual

Accounting

z Determinewhatnetincomehasbeenearned

duringaperiod,notjustwhatcashhasbeengeneratedduringtheperiodfromoperationsz Why?Tocapturetheeconomiceventsthathave

occurredduringtheperiodz Determine revenues applying the revenue-

recognitionprinciples

z Report as expenses those costs that havebeen or will be incurred to generate thoserevenues

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AccrualsandCashflows:

FourCases1)Cashprecedesexpense

TimePayCash RecognizeExpense(a) (b)

BalanceSheetDate

Examples: Rentpaidinadvance,PrepaidInsurance,PP&E,Inventory

Associatedentries:

(A) = (SE)Cash PrepaidRentPrepaidRent Ret.Earn.

(a) $ +$

(b) $ $(rentexpense)

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Example:PrepaidRent

z AssumeonJan1,youpayrentforthenextyearfor@$1,000

permonthDrPrepaidRent(CA) 12,000

CrCash(CA) 12,000

z Sayyoumakeadjustingentriesattheendofeverymonth.Attheendofthefirstmonth,onJan30th,youwouldrecordthefollowingexpense:

DrRentExpense(RE) 1,000

CrPrepaidRent(CA) 1,000

z

The first entry increase a current asset (Prepaid Rent) and

decreasedCashz The second entry decreased Retained Earnings and also

decreasedacurrentasset(PrepaidRent)

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AccrualsandCashflows:

FourCases2)Cashfollowsexpense

TimeRecognizeExpense

(a) (b)PayCash

BalanceSheetDate

Examples: Taxespaidafteryearend,Salariespaidonthe15thofthemonth,baddebtexpense,warrantyexpenses

Associatedentries:

(A) = (L) (SE)Cash SalariesPayable* Ret.Earn.

(a) +$ $(salaryexpense)

(b) $ $

*sometimesalsocalledaccruedsalaries 13

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AccrualsandCashflows:

FourCases3)Cashprecedesrevenue

TimeReceiveCash RecognizeRevenue

(a) (b)

BalanceSheetDate

Examples: AirplaneticketssoldinadvanceNewspapersubscriptionssoldinadvance

Associatedentries:(L) (SE)

Cash UnearnedRevenue*UnearnedRevenue* Ret.Earn.(a) +$ +$

(b) $ $(revenue)*sometimesalsocalleddeferredrevenue

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AccrualsandCashflows:

FourCases4)Cashfollowsrevenue

TimeRecognizeRevenue ReceiveCash

(a) (b)

BalanceSheetDate

Examples:AccountsReceivableGoodsshippedbutcashnotyetreceivedServicesprovidedbutcashnotyetreceived

Associatedentries:(A) (A) (SE)Cash AccountsReceivable Ret.Earn.

(a) +$ +$(revenue)(b) $ $

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RevenueRecognition

z Revenuerecognitionprinciples:Servicehas

beenprovidedbythecompany,customerhasbeenbilledandthereisreasonablecertaintyofcashcollection

z Issuesinrevenuerecognition

z Creditsales

z

Warrantiesandreturnsz Bill&holdsales,SAB101

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AccountsReceivable

z Notallaccountsreceivableswillbecollected

incash

z The balance in Allowance for DoubtfulAccounts at the end of the year reflectsestimateddefaults.

z Baddebtexpenseisrecordedattheendof

everyperiodtoadjust thebalanceinADAtothedesiredamount

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IncomeStatementandBalance

SheetRelationsAccounts Receivable (A)

Beg BalanceAmount of Credit Sales

Cash collectedWrite-offs

Ending balance

Allowance for doubtful accounts (XA)

Beg Balance

Amount of Bad Debt ExpenseWrite-offs

Ending balance

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ARandADAAccountBalances

AccountsReceivable(A) AllowanceForDoubtful

Accounts(XA)

BeginningBalance BeginningBalance

+CreditSales+AmountsRecordedas

CashCollected BadDebtExpense

NetAmountsWritten NetAmountsWritten

Off Off

=EndingBalance =EndingBalance

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Inventories- TheKeyEquation

Inventory

Beg.Inventory

Purchases/Production

Costofgoodssold

End.Inventory

Beg.inventory+purchases/production- COGS=End.inventory

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AccountingforInventoryA Comparison of LIFO and FIFO

Income Balance

Statement Sheet

LIFO

FIFO

New costs*

New costs

Old costs

Old costs

*if LIFO liquidation old and new costs

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UsingtheLIFOReserve:

IncomeStatementEInv

EInvFIFO=BInvFIFO+Purchases COGSFIFO

LIFO=BInvLIFO+Purchases COGSLIFO

EInv

Subtractingthesetwoequationsyields:

FIFO EInvLIFO=BInvFIFOBInvLIFO (COGSFIFOCOGSLIFO)

EInvFIFO EInvLIFO (BInvFIFOBInvLIFO)=COGSLIFOCOGSFIFO

EndLIFOReserve Beg.LIFOReserve=COGSLIFOCOGSFIFO

ChangeinLIFOReserve=LIFO-FIFOdifferenceinCOGS

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LIFOLiquidation

z RelevantforfirmsthatreportLIFO

z Occurswhenproduction

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CashFlowStatements

z Changeinnetcash=

Operatingcashflows+

Investingcashflows+

Financingcashflowsz Giventwo,youshouldbeabletoworkoutthe

third

z Twomethods:IndirectandDirect

z

Fortheexam:worryaboutIndirect

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TheIndirectMethodz Operating

z StartwithNetIncome

z MakeadjustmentstoarriveatCFO(cashflowfromoperationsoroperatingcashflows)

z Investingz PurchaseofPPEand/orotherlong-termassets(outflows)

z ProceedsfromsaleofPPEand/orotherlong-termassets(inflows)

z Financing

z Dividendspaid(outflows)z Issuanceofsecurities(inflows)

z Retirementofsecurities(outflows)

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OperatingCashFlows(CFO)z

NetIncomeincludesnon-cashrevenuesandnon-cashexpensesz These non-cash revenues/expenses usually are captured in changes in

operating current assets and operating current liabilities (recall the two-sidednessofallentries)z

Step1: Identifyoperatingnon-cashcurrentassetsandoperatingcurrent liabilities

z Step2: Identifynon-cashrevenuesorexpensesthatdonotaffectoperatingcurrentassetsoroperatingcurrent

liabilities(example:DepreciationExpense)z

Step3:z Startwithnetincomez Add /(subtract) to it anynon-cashexpense /(revenue) thatdoesnot affect operating

currentassetsoroperatingcurrentliabilities**z Subtract/(add)anyincrease/(decrease)innon-cashoperatingcurrentassets

z Add/(subtract)anyincrease/(decrease)inoperatingcurrentliabilitiesz ArriveatCFO

** Sometimestransactionsthathavecashconsequencesaresimilarlyadjustedoutoftheoperatingsectionbecausetheyarenotconsideredaresultofoperatingactivitiesdonotworryaboutthisyet.

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Summary

z Understandhoweventsaretranslatedinto

accountingreportsviatheBSE.

z Understandthedifferencesbetweenaccrualaccountingnumbersandcashflows

z Revenuevs.cashcollected

z COGSvs.purchasesvs.cashpaidforpurchases

z

Reconciliationnetincomeandcashflowfromoperations

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