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lecture10More on the Statement of Cash Flows,Exam Review.pdf

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    1

    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

    2

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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

    5

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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

    6

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    DebitsandCredits

    zAssets=Liabilities+OwnersEquity

    z Increasesinassetsaredebits

    z Increasesinliabilitiesarecredits

    z IncreasesinOwnersEquity(CapitalStock,RE)arecredits

    z RevenuesincreaseRetainedEarnings

    Credits

    z ExpensesreduceRetainedEarnings- Debits

    7

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    AccountingEntries

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

    8

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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

    10

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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)

    11

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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

    14

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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) $ $

    15

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    RevenueRecognition

    z Revenuerecognitionprinciples:Servicehas

    beenprovidedbythecompany,customerhasbeenbilledandthereisreasonablecertaintyofcashcollection

    z Issuesinrevenuerecognition

    z Creditsales

    z

    Warrantiesandreturnsz Bill&holdsales,SAB101

    16

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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

    20

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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

    21

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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

    25

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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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