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Financial Accounting: Class
Notes

Corporate Acquisitions: Class notes

1
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1 Financial Accounting -

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Class 1
o Three homework assignments
Accounting
o “language of business”
o Collection, processing and reporting of info about activities and events that affect the
organization
Three types of accounting users
o Financial Accounting and Reporting: recording financial transactions, position and results and
communicating it to outside stakeholders
o Managerial Accounting and Reporting: communicating the position and results of firm
internally
...

Accounting Principles
o Generally Accepted Accounting Principles (GAAP)
▪ SEC has authority to set GAAP
• SEC delegates this authority to the Financial Accounting Standards Board
(FASB)
• FASB rules are called Statements of Financial Accounting Standards
(SFAS) – currently over 150 rules
▪ Attributes of ideal accounting system
• Reliability – verifiable by an independent party
• Relevance – it has to be timely, and have feedback value and predictive
ability to a certain extent (you may want to use the info to make future
decisions)
▪ Other important accounting concepts
• Conservatism – report bad news but not good news if there is uncertainty
• Materiality – if tracking an account is costly and reporting it doesn’t change
decisions, it is not worth it
...


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Corporate Acquisitions: Class notes
▪ Accounting numbers = economic truth + measurement error + incentives
Changes to Accounting Rules and Regulation – can change due to lobbying, political
pressure, economics and technological change
Principal Activities of a Firm
o Sources of capital
▪ Creditors
▪ Owners
o Investing Activities
▪ Inventory
▪ PPE
o Operating Activities
▪ Creates value
o Value creation
▪ Earnings, profits, etc
...
)
o Users
▪ Analysts/Media – third party information providers
▪ Investors – large institutions and individuals
International Financial Reporting Standards (IFRS)
o Set of global accounting standards for the preparation of public company financial statements
o Developed by the International Accounting Standards Board (IASB)
o IASB is an independent accounting standard-setting body based in London
o 12,000 companies in almost 100 nations have adopted IFRS
...
g
...

o NET INCOME = REVENUES – EXPENSES
▪ Revenues – inflows of assets from selling and providing goods or services
▪ Expenses – outflows of assets used in generating revenues
o Note: there is nothing in these definitions that referto cash
o Balance Sheet vs
...

o Cash flows are categorized into:
▪ Operating: Providing goods and services
▪ Investing: Choice of assets used to run operations
▪ Financial: Raising capital to pay for assets
Financial Statements: The Link
o CASH + NONCASH ASSETS = LIABILITIES + CONTRIBUTED CAPITAL +
RETAINED EARNINGS
Other Financial Reporting Items
o Statement of Shareholders’ Equity – schedule that reconciles the change in S/Hs equity
accounts during a period of time
o Notes to financial statements
o Auditors’ opinion
o Financial highlights, including trends
o Management’s Discussion and Analysis
o CEO/CFO Certification
CHAPTER 2
The Balance Sheet (p59-61 – nice summary of balance sheet accounts)
Assets

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Corporate Acquisitions: Class notes
o

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Definition: an asset is an economic resource that is expected to provide future economic value
(i
...
generate future cash inflows or reduce future cash outflows)
▪ “All assets are future benefits; however not all future benefits are accounting assets”
▪ Executory (uncompleted) contracts do not result in assets (must be an exchange)
o An asset is included in the balance sheet (i
...
recognized) when:
▪ Ownership – the firm has acquired the right to use it in a past transaction or
exchange
▪ Measurable – the value of its future benefits can be measured with a reasonable
degree of precision
o Examples
▪ Cash, Inventory, Accounts Receivable, PPE (property, plant, equipment)
▪ Brand name or famous CEO (Warren Buffett) CANNOT be put on the balance sheet
▪ Patents are intangible assets (R&D) – GAAP requires that you expense the costs of
R&D
...
How can you
verify the value? However, if you buy it from an outside party that establishes a
reliable value
...

• Exception: marketable securities (valued at Net Realizable Value)
Assets: Classification
o Current Assets: assets expected to be realized in cash within one operating cycle (typically
one year)
▪ Examples: inventory, accounts receivable
o Noncurrent assets: assets that are NOT expected to be realized in cash within one operating
cycle
▪ Examples: PPE
o Why is this relevant? Liquidity – it is a measure of liquidity and how quickly you can get the
assets out of the firm
...
e
...
e
...
It is not measurable
...
You do have to disclose them in notes
...
e
...
g
...
g
...

▪ If ACID test ratio is less than Current Ratio → Inventory is a big deal
...
g
...

o Inputs to Measuring Fair Value (FV)
▪ Level 1: Observable quoted prices in active markets for identical assets/liabilities
(MOST RELIABLE)
▪ Level 2: Observable inputs other than quoted market prices within Level 1
• Includes quoted prices for similar asses/liabilities in active market
• Includes quoted prices for identical asses/liability in markets that are not
active
• Observable factors relevant to using present values of cash flows to measure
FV
▪ Level 3: Unobservable inputs which reflect the reporting entity’s own assumptions
(Management’s assumptions) about the assumptions market participants would use
in pricing an asset/liability
...
(A=L+SE)
o Two basic components of S/Hs equity
▪ Contributed capital: initial investment of S/Hs
• Preferred stock – first preference for dividends but no voting rights
...
g
...
e
...
5
▪ Microsoft: 6
...
03
▪ NOTE: while BoA holds mainly financial assets that are recorded in the accounting,
MSFT and DELL have brand name, R&D, etc
...
Analyze Transactions
o 2
...
Post to a ledger which is a collection of T-accounts → unadjusted trial balance
o 4
...
Closing entries
o END OF PERIOD – three financial statements are created
Double Entry Accounting System
o Every economic event has two sides – a give and a take
o Both sides of the transaction are to be recorded
o The basic accounting equation remains in balance
▪ Assets = Liabilities + Shareholders’ Equity
▪ 1) Inv up $100k, Acct Payable up $100k
▪ 2) Cash up $3k, Accounts Receivable down $3k
▪ 3) PPE up $40M, Notes payable up $40M
▪ 4) Cash up $300M, Common stock up $300M
▪ 5) Cash down $20k, Accounts payable down $20k
o Assets, Liabilities and S/Hs Equity are “stored” in accounts
▪ T-accounts: easy way to keep track of activity and multiple transactions in an
account
o Account balances
▪ Ending balance = beginning balance + increases – decreases
o Debit – an entry which
▪ Is made on the left side of the T-Account

Page 7

Corporate Acquisitions: Class notes

o

o
o

▪ Increases an asset account
▪ Decreases a liability account
▪ Decreases a S/Hs equity account
Credit is an entry which
▪ Is made on the right side of the T-Account
▪ Decreases an asset account
▪ Increases a liability account
▪ Incrases a S/Hs equity account
Every transaction must have at least one debit and at least one credit
Sum of debits = sum of credits
▪ E
...
Dr
...
100k; Cr
...

o Shareholders’ Equity: amount of funds owners have provided and, in parallel, their claims
on the assets of a firm
...

o Historical valuation: reflects the acquisition cost of assets or the amounts of funds originally
obtained from creditors or owners
o Current Valuation: reflects the current cost of acquiring assets or the current market value of
creditors’ and shareholders’ claims on a firm
...

o Expenses: measure of outflows of assets (or increases of liabilities) used in generating
revenues
...

- Equations
o Assets = Liabilities + Shareholders’ Equity
o Net Income = revenues – expenses
- PROBLEM 2
...

▪ Dr
...
Building 450000
▪ Cr
...
Inventory 280,000
▪ Cr
...
Accounts Payable 250,000

Page 8

Corporate Acquisitions: Class notes

o
o
o

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-

-

▪
▪

Cr
...
02*250k=5k)
Cr
...
Prepaid Insurance 12000
Cr
...
Cash 300,000
Cr
...
Equipment 80,000
Cr
...
12000
o Land 50000
o Buildings 400000
o Equipment 80000
o Accounts Payable: Cr 30000
o Notes Payable: Cr
...
300000
o Common stock: Cr
...
g
...

o Advantages
▪ Provides reliable information about cash flows
▪ Intuitive and easy to understand
▪ Objective – timing of transactions is clear

Page 9

Corporate Acquisitions: Class notes
o

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Disadvantages
▪ Delay in recording revenues/expenses until cash changes hands
▪ Poor matching of resources expended to benefits received
▪ Subject to manipulation – for example, firm can delay recording an expense by
postponing cash payment
o Accrual Accounting
▪ Accrual Accounting: method of accounting where revenues and expenses are
recorded on an economic basis regardless of the actual flow of cash
• Revenues recorded when benefits are earned
o When is revenue earned?
• Expenses recorded when resources are expended to produce benefits
...

▪ 2) Concentrate costs in one quarter so future quarters look
better
...

▪ 3) Financing Arm of company
▪ 4) Cutting out R&D costs – particularly pharmaceutical
and software companies (other discretionary expenses)
▪ 5) Earnings guidance to analysts – manage analyst
expectations so market doesn’t expect something higher
...
will continue
...

▪ Timing of revenue recognition
▪ Measurement of revenue
▪ Timing of expense recognition
▪ Measurement of expenses
o Over the life of the firm:
▪ Cash income = accrual income
Revenues
o Revenues: benefits (or increases in net assets) earned by a firm for providing goods and
services
▪ Net Assets = assets – liabilities = Shareholders’ Equity
o Revenue recognition criteria
▪ Firm has delivered the goods to the customer or performed all or most of the services
(i
...
it has earned the revenue)
▪ Collection of cash (or other benefits) is reasonably assured though some uncertainty
may remain (bad debts, warranties)
▪ Cash (or other benefits) to be received is measurable

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Corporate Acquisitions: Class notes
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How much revenue is recognized in December?
o A) $500k – because goods delivered – sold on credit
o B) 0 – this was already recorded in October
o C) $10k – this is what was earned in December
o D) 0 revenue – they would have advance from customers
o E) This is not an income statement item – this would go into “paid in capital”
Expenses
o Definition: Decreases in net assets (not necessarily cash) that arise in the process of
generating revenue
...
DIVIDENDS
DO NOT GO INTO THE INCOME STATEMENT
Basic Accounting Equation with Revenues, Expenses and Dividends
o Assets
=
Liabilities +
Shareholders Equity
o Shareholders’ Equity = Contributed Capital + Retained Earnings
o Retained Earnings = Retained Earnings Beginning + Net Income for Period – Dividend for
Period
o Net Income = Revenues for Period – Expenses for Period
Purpose and Use of Individual Revenue and Expense Accounts
o Revenue and expenses could be recorded directly to the Retained Earnings account
o It is more informative to collect revenues and expenses separately during the accounting
period
...
Their balances flow into Retained Earnings
...
In contrast, the balance sheet
accounts (asset, liability and S/Hs equity) are permanent accounts whose balances carry over
each period
Double Entry Accounting System
o Revenue: increases credit the account (increase an asset); Decreases debit the account
o Expenses: increases are debited; decreases are credited
o Closing revenue account
▪ If you have a credit in revenue
▪ Dr
...
Retained Earnings by X
▪ Expenses, if you have a balance of Y
▪ Cr Expense Account by Y
▪ Dr
...
33 – Moulton Corporation
o Accrual basis of accounting
o 1) purchased inventory on account costing $1,100,000 from various suppliers
▪ Dr
...
Accounts Payable 1,100,000
▪ We start with a beginning balance of $343,000 for cash, etc
...
Accounts Receivable 2,000,000 (this goes to balance sheet)
▪ Cr
...
Cost of Goods Sold 1,200,000
▪ Cr
...
Cash 1,400,000
▪ Cr
...
Cash 950,000
▪ Dr
...
The firm consumed
all of the benefits of these services during Year 13
...
Cash 625,000 (balance sheet)
▪ Dr
...
The
note is due on 6/30 Year 13
...
In year 13, firm
repaid note payable to supplier with interest
...
Interest Expense
...
Cash 2400
▪ Dr
...
Cash 80000
o 8) The firm borrowed $300k from a bank
...
The interest is payable on January 1 of each year, beginning January 1, Year
14
...

▪ The 300,000 was from year 12 so it should have already been reflected
...
Interest Expense
...
Interests Payable 24,000 (liability on balance sheet)
o 9)
▪ Dr
...
Prepaid Insurance 12,000 (this reverses out the asset they had)
o 10) Recognized depreciation expense for Year 13
...
Also, on December 31 it acquired equipment costing $80k which has an estimated
useful life of 5 years
...
Depreciation Expense 18,000
▪ Dr
...
Accumulated Depreciation 34,000 (“contra asset” account → this goes into
balance sheet and is written under the building or equipment you are depreciating
...
It works like a liability because when it increases we credit
...
The
income tax rate is 40%
...

▪ Sales Revenue: 2,000,000
▪ Expenses
• Cost of Goods Sold: 1,200,000
• SGA Expense: 625,000
• Insurance: 12,000

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Corporate Acquisitions: Class notes
• Depreciation: 34,000
• Interest: 26,400
Total Expenses: 1,897,400
Net Income Before Income Taxes: 102,600
Income Tax Expense at 40%: (41040)
Net Income: 61,560

-

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▪
▪
▪
▪
▪
▪ Dr
...
Tax Payable 41,040
▪
o Closing transactions
▪ Dr
...
Retained Earnings 2,000,000
▪ Cr
...
Retained Earnings 2,000,000
▪ Cr
...
Retained Earnings 625,000
▪ Cr
...
Retained Earnings 12,000
▪ Cr
...
Retained Earnings 34,000
▪ Cr
...
Retained Earnings 41,040
Types of Journal Entries
o Transaction based entries: sale of product, purchase materials, pay salaries
o Adjusting journal entries:
▪ Made at the end of an accounting period to reflect non-cash economic events that
occurred during the period or prior transactions that were improperly recorded during
the period
...
Unearned Revenue
• Cr
...
Cash 1400
• Cr
...
Cash 1400
• Cr
...
Revenue 1400
• Cr
...
Cost of Goods Sold 5000
• Cr
...
Equipment 5,000
• Cr
...
Depreciation 500 (5000*1/5 * ½)
• Cr
...
Cost of Goods Sold 5000
• Dr
...
Depreciation 500 (5000*1/5 * ½)
• Cr
...
Look at what is
likely to persist in the future
...


CLASS 3
- Revenue Recognition Principles
o Reasonably Certain – that you will collect it from customers
o Delivered goods or provided the service – at least most of the service or most of the goods
o Measurable – must be measurable or else we can’t recognize it in financial statements
- Staples Example
o 1) Review the revenue recognition policies of Staples discussed in Note A (Summary

of Significant Accounting Policies)
...

▪

o

o

o
o

Revenue is recognized at the point of sale for the Company’s retail operations
and at the time of shipment for its delivery sales
...
The unrelated third party is the legal obligor in most of the areas
they administer and accordingly bears all performance obligations and risk of loss
related to the service plans sold in such areas
...
In certain areas
where Staples is the legal obligor, the revenues associated with the sale are
deferred and recognized over the life of the service contract, which is typically
one to five years
...

2) What is Staples’ accounting policy for advertising expenditures? What percent of Staples’
Sales are advertising and marketing expenses in fiscal 2005, 2004 and 2003? What percent of
‘Operating and Selling expenses’ are advertising and marketing expenses in fiscal 2005, 2004
and 2003?
▪ Staples expenses the production costs of advertising the first time the
advertising takes place, except for the cost of direct-response advertising, primarily
catalog production costs, which are capitalized and amortized over their expected
period of future benefits (i
...
, the life of the catalog)
...
4 million at January 28, 2006 and
$30
...
Total advertising and marketing expense was
$588
...
0 million and $492
...

• This is consistent with GAAP
...

• If you are looking for a particular expense, sometimes you need to look at
the footnotes
...
Show the journal entry made by Staples to reflect the amount of dividends declared during
fiscal 2005
...

▪ Retained Earnings
▪ Credit
Debit
▪
2818163
▪ Net Income
834409
▪ Dividends
?? (123402)
▪
Ending Balance
3529170 (this increases because of net income)
Retained Earnings End Balance = RE Beginning Balance + Net Income – Dividends
How write as a journal entry?

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Corporate Acquisitions: Class notes

o

o
o
o

o
o
o
o

o

o

▪ Dr
...
Dividends Payable (or Cash)
123402
4
...

▪ Issued vs
...
Outstanding
▪ Authorized # shares – total number of shares a firm can issue over its life
▪ Issued # shares – don’t take away the number they purchased back
▪ Repurchased shares (e
...
“Treasury stock”)
▪ Outstanding # shares (e
...
“float”) – shares issued – shares repurchased
• Issued: 829,695,100
• Repurchased: 99,253,565
• Outstanding = Issued – Repurchased = 730441535
REFERS TO GOOGLE
5
...
Compute the percentage change in revenue from fiscal 2003 to fiscal 2004 and from fiscal
2004 to fiscal 2005
...
’ [Note: you
should exclude the ‘one-time’ expense recorded in 2004 and 2005 related to the Yahoo
dispute settlement and the Google Foundation contribution, respectively]
...
What is the date of the financial statements? What is the date of the auditors report? When
did the stock market learn about Google’s results?
8
...

a) How would you characterize the Google’s results for fiscal 2005?
b) Review the stock market charts for the period January 1, 2005 through May 1, 2006 for
Google
...
Compare Google’s 2005 stock price performance with the
performance of the broader set of firms trading on the NASDAQ exchange
...
Why do you think Google
computes and reports these non-GAAP numbers? How might they be used by market
participants? The last page of the press release includes a reconciliation from the GAAP
income statement measures to the non-GAAP measures – discuss the 2 items that are reflected
in GAAP Income from Operation that are excluded from the non-GAAP equivalent – what
does each item capture and why would Google exclude each in computing the non-GAAP
measure?

CLASS 3
- Review of Accrual Accounting
o Assets = Liabilities + Owners’ Equity (this is always balanced)
- Assets Increase by:
o Borrowing (Liabilities increase)
o Owner investments (contributed capital increases)
o Earnings Income (Retained Earnings increases)
- Net Income = Revenues – Expenses
o Revenues are inflows of assets

Page 16

Corporate Acquisitions: Class notes
o
o

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-

-

-

-

-

-

Expenses are outflows of assets
Revenues and expenses can be recognized even when cash does not chance hands
...
People want to know the sources and
uses of cash (e
...
lenders, suppliers, etc
...
“Interest and dividends collected” (operating)
▪ Interest and taxes paid (operating)
Methods of Presenting the Statement of Cash Flows
o Direct Method
▪ Lists cash receipts and disbursements by source/use of funds
▪ Always used for investing and financing activities
▪ Rarely used for operating activities
o Indirect method
▪ Only used for operating activities
▪ Goal is to reconcile net income with cash from operations by removing noncash
items from net income
• Net Income = Cash Revenue + NonCash Revenue – Cash Expenses –
Noncash expenses
• Net Income (cash) = Cash Revenue – Cash Expenses)
▪ Almost every company uses this method for operating activities
Statement of Cash Flows: Indirect Method
o We’ll focus on indirect format which is used by most firms
▪ Involves reconciling net income to cash flow from operations by accounting for noncash items embedded in net income
• Net Income = Cash Revenue + Noncash Revenues – Cash Expense –
NonCash expense
▪ Start with Net Income

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Corporate Acquisitions: Class notes
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-

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Cash Flows from Operations = Net Income – Non-cash revenues +
noncash expenses
o Types of Adjustments between net income and cash from operations
▪ Non-cash expenses (depreciation
▪ Non-operating items in net income
• Gains and losses on equipment sales
▪ Accrual vs
...
cash receipts)
Indirect Method: A Summary
o ??
Statement of Cash Flows: Examples of Adjustments
o Depreciation is a non-cash expense – why?
▪ When you purchase a long-term asset you spend cash but do not expense the amount
right away (matching principle)
▪ Example
• Revenue (Cash) = 100
• Expenses, cash = (40)
• Depreciation (20)
• Net Income = 40
• CFO = NI + Depreciation = 60
• Note: Anything that is a noncash expense is added back in
...
Receivables will go up by the difference in cash and noncash
revenues
• Indirect method: 1400 – 15 = 1385
▪ Example 3
• Asset bought for $8 and depreciated $3
• Net Book Value = $8-$3 = $5
...
Cash
1 (investing section of SCF)
o Dr
...

3
o Dr
...
Asset
8
• Whenever there is a gain or loss from property you have to adjust the
income statement
...
30 from the text
...
Cash
10,000
▪ Dr
...
Dep
40,000
▪ Dr
...
Equipment
50,000
▪ Cr
...
Cash
12,000
▪ Dr
...
Dep
40,000
▪ Dr
...
Equipment
50,000

Page 18

Corporate Acquisitions: Class notes
▪
o

o
o

Cr
...
Cash
8,000
▪ Dr
...
Dep
40,000
▪ Dr
...
Equipment
50,000
▪ Cr
...

What is the effect on the Cash Flow Statement?
▪
Sell for $10000
• Operations
o Income
100
o Depreciation
15
o Gain on sale
0
o Loss on sale
0
o Changes in work cap (40)
o Cash flows from operations
75
• Investing
o Acquisition of Buildings & Equipment
o Proceeds from Sale of Equipment
o Cash flow from investing
• Financing
o Repayment of long-term Debt
(40)
• Net Change in Cash
15
• Cash, Beginning of year
27
• Cash, End of year
42
▪ Sell for $12000
• Operations
o Income
102
o Depreciation
15
o Gain on sale
(2)
o Loss on sale
0
o Changes in work cap (40)
o Cash flows from operations
75
• Investing
o Acquisition of Buildings & Equipment
o Proceeds from Sale of Equipment
o Cash flow from investing
• Financing
o Repayment of long-term Debt
(40)
• Net Change in Cash
17
• Cash, Beginning of year
27
• Cash, End of year
44
▪ Sell for $8000
• Operations
o Income
98
o Depreciation
15
o Gain on sale
0
o Loss on sale
2
o Changes in work cap (40)
o Cash flows from operations
75
• Investing
o Acquisition of Buildings & Equipment
o Proceeds from Sale of Equipment
o Cash flow from investing

(30)
10
(20)

(30)
12
(18)

(30)
8
(22)

Page 19

Corporate Acquisitions: Class notes
•

-

-

-

Financing
o Repayment of long-term Debt
(40)
• Net Change in Cash
13
• Cash, Beginning of year
27
• Cash, End of year
40
Accumulating Information for a SCF
o A = L + S/E
o REVIEW: Deck 3, Slide 15
o Operating
▪ Generally, all changes in current assets and current liabilities
▪ Exceptions
• Marketable Securities → investments section
• Short-term borrowing → Financing
• Otherwise, changes in current assets and current liabilities go to operating
o Investing
▪ Generally, changes in long-term assets (excluding depreciation which is not a cash
transaction)
o Financing
▪ Generally, change in long-term liabilities and changes in contributed capital accounts
Problem 4-35
o If income statement is not provided, you will have the information required
...

How?
• Machinery goes down (Cr) by $150,000
o They must have purchased new machinery and buildings
o Amount purchased is $118 (plug) purchased for year (Dr
...
Depreciation of $120,000
= $30000
...
This is a loss of $5000
...
We add
that back
...

What can firms do to mislead investors regarding cash flows?
o Increase or decrease in assets that aren’t reflected
...
Companies can still follow
GAAP but they can delay paying suppliers, push customers to pay earlier which isn’t
always a good business practice
...

o Classification
▪ Most investors look at cash from operations
...

Are they doing well in their operations
...
The numbers still add up but the operating amount doesn’t
change
...

Red flags – watch out for if looking at companies
o Compare NI & CFO number → if earnings and cash flow are going in different directions
▪ You want the company to recover the cash
...
If they are getting receivables but no
cash, why?
o Free Cash flow number → analysts look at this
...
)
▪
= CFO (cash flow operations – CFI (cash flow from investments)
▪ If you have negative free cash flow, look at days to flameout → this is liquid
resources of firm / cashflow per day
...
S
...

What was the entry to record the sale of the property?

Page 21

Corporate Acquisitions: Class notes
▪
▪

o

o

o

Proceeds from Disposition of Property $53
• They got Cash of $53
Accumulated Depreciation
• What was the depreciation of the sold PP&E? How do we figure it out?
• We know the gain was $3 (subtracted from operations)
• We know that it cost $53, so we know accumulated depreciation was $50
...
Cash 53
• Dr
...
Gain 3
• Cr
...
How much did U
...
Airways receive in 2001 from these grants and
how much of this amount was in cash?
▪
Dr
...

7) Why is the amount for “Non-cash Charges” an addition to net income in determining cash flow from
operations?
▪
Because it is non-cash
8) Why are increases in “Accounts Payable and Accrued expenses” an addition to Net income in
determining cash flow from operations?

▪

They are not cash
...
Therefore,
you add it back because you only want to find the cash part of the period
...


Class 4: Class Notes for Chapter 6
- Accounts Receivable and Revenue Recognition
o Revenue is recognized when
▪ 1) firm has delivered the goods/services to the customer
▪ 2) Collection of cash is reasonably assured
▪ 3) Cash to be received is measurable
o Accounting for bad debts from customers and other costs associated with accounts receivables
focuses on the last two criteria
o Objective when reporting Revenue and corresponding A/R:
▪ Reflect balances at the net amount of cash expected to be received: this reflects the
gross amount of Revenue and A/R net of estimated uncollectible amounts
...

- Accounting for Uncollectible Accounts: DIRECT WRITE-OFF METHOD
o Bad debt expense is recognized in the period in which a specific account is deemed
uncollectible
...
Cost/month $8000
...
End of 1st month, no entry was recorded
...


Depreciation
▪ Proceeds of sale of PPE = net book value + gain on sale
▪ Cash from investing includes the proceeds from the sale
Cash flow from financing (Direct Method)
▪ Issue (+)/repurchase stock (-)
▪ Dividends paid (-) (dividend revenue from investments is in cash flow from
operations)
▪ Debt issued/retired (interest payments are in cash flow from operations)
o Non-cash transactions are not reported in the cash flow statement
Accounts Receivable
o At time of sale
▪ Dr AR, Cr Revenue
▪ Dr bad debt expense, Cr Allowance for uncollectible accounts (contra asset)
▪ Bad debt expense: estimated using percentage of sales; aging of AR
o When specific customers default
▪ Dr
...
AR
o When customers pay in cash
▪ Dr
...
AR
o Cash flow presentation
▪ Net Income +- ∆ net AR
o

-

Page 23

Corporate Acquisitions: Class notes

-

-

• Net AR = Gross AR – Net Allowance
▪ Net Income + bad debt expense +/- ∆ net AR – write-offs
o Income recognition before and after sale
o Ratio Analysis – p237
EXAMPLE
o Suppose customer owing $5000 in prior period sales defaults
...
Allowance Account
5000
▪ Cr
...
)
o Manufacturing firms
▪ Raw materials inventory, work-in-process (WIP) inventory, finished goods inventory
▪ Product costs (direct and indirect) included in work in process inventory]
• Dr WIP, Cr
...
/insurance payable
• RMend = beginning balance + purchased – RM used
• WIPend = Beginning Balance +Raw materials being used + Direct Labor +
Overhead – completed units value
• Finaished Goodsend = Beginning balance + Completed Units – COGS
o FIFO Inventory + LIFO Reserve (credit balance) = LIFO Inventory
▪ Excess of FIFO over LIFO is the LIFO Reserve

11/10/08
- GAP and AOL Case
- Product Development Costs
o 1) Capitalize Costs
o 2) Amortize Costs
o 3) Expense when Technological Feasibility is not reached
- Journal Entreis
o Capitalize
▪ Dr
...
Cash/Payable
51
o Amortize
▪ Dr
...
Product Development Cost (Net)
• Or
▪ Cr
...
Product Development Expense
95
▪ Cr
...
Deferred Subscriber Acquisition Cost
363
▪ Cr
...
Amortization Expense
126
▪ Cr
...
Deferred Subscriber Acquisition, Net
126
o Writeoffs
▪ Dr
...
Stmt)
0
▪ Cr
...
No amortization Expense
▪ 2
...
Full Expensing of all Capitalized Costs
• Everything going to the asset on balance sheet should hit income statement
as expense
...
g
...
g
...
g
...
g
...
This is very dicey
...

• Dr
...
Restructuring Liability
Long-term Liabilities
o Value at the present value of future cash payments
o There are many types of long-term debt with differing types of timing of required future cash
flows of interest and principal
o Common examples
▪ Mortgages
▪ Coupon bonds
▪ Serial bonds
▪ Zero coupon bonds
o We’ll illustrate using coupon bonds which have periodic payments of interest with the
principal amount repaid in one lump sum at the maturity of the bond
...
g
...
Interest Expense
o Dr
...
Cash
o Ending Balance of Bond Premium → eventually becomes zero and Bond value goes down to
par value
...
Cash
6627309
• Dr
...
Bonds Payable
8000000
▪ Market Rate: 10%, period rate 5%
▪ USE TABLE 2 and TABLE 4
o Balance Sheet
▪ Bonds Payable
▪ LESS (Bond Discount)
▪ NBV of Bond
o Bond Amortization Table
▪ 1,2,3,4,5,6
▪ Period, Liability at Beginning Amt Raised, Interest Expense (at 5%), Coupon
Payment (at 4%), Difference: decrease in book value, Liability at End of Period
▪ Difference: decrease in book value = 3 – 4
▪ EFFECTIVE INTEREST RATE METHOD
o Amount by which the bond discounts gets “amortized” every period
...

o How much is the liability changing? This is the same as how much the bond value is
changing
...
Interest Expense
▪ Cr
...
This amount is the difference between
the actual interest expense and the amount actual shelled out in cash
...
Cash
o When you are finding out the book value or to compute interest expense, use the historical a
rate
...

o Gain = Net Book Value – Cash Outflow to Retire the Bonds (MV)
▪ If the cash you have to pay is less than the book value, you have a gain from retiring
the bond
...

▪

-

-

TRIBUNE CASE
o 7
...
What was the adjusting entry recorded by The Tribune Co
...
LYONs is a
zero coupon bond
...
57% but the coupon rate was zero
...


Page 27

Corporate Acquisitions: Class notes
▪

o

o

o

Typical journal entry
• Dr
...
Bond Discount
• Cr
...

• Bond Discount Account (“Unamortized bond discount”)
o LYONs are zero coupon bonds → interest expense = amount of
amortization of discount
o Alternative: Change in net book value (NBV) of bond = 291,644 –
281,602 = 10,042
...
→ this is true even if it is not a zero coupon bond
...
This is the amount the bond
discount changed
...
If The Tribune Co
...
0357*291644) = 302,056
• For a zero coupon, interest expense is the same as the amount the bond
discount changes which is how the net book value changes as well
...

10
...
to retire the 6
...

▪
6
...

▪ Face Value = amount due at maturity
• Face Value – Bond Discount = Net Book Value (NBV) of Bond
• NBV + Unamortized Discount = Face Value
• Face Value = 199,449 + 551 = 200,000
▪ Coupon Payment = Face Value * coupon rate
• Coupon Payment = 200,000 *
...
Interest Expense
10,526 (plug)
o Cr
...
Cash
9975
• Maturity Entry
o Dr
...
Interest Payable
3325
o Dr Interest Expense
10526
o Cr
...
Cash
213300
11
...
45% notes due 2009 at December 31, 2001?
At December 31, 2000?
▪ Face Value = NBV + Unamortized Discount
▪ Face Value 12/31/2001 = NBV12/31/2001 + Unamortized Discount(12/31/2001)
• FV12/31/2001 = 394370 + 5630 = 400,000

Page 28

Corporate Acquisitions: Class notes

▪

• FV12/31/2000 = 393649 + 6351 = 400,000
• NOTE: face value will not change (unless they retire part of the bond)
• Coupon Payments =
...
Bond Discount
721
• Cr
...
What adjusting journal entry was made on December 31, 2001 relating to the 7
...
You may assume that coupon interest payments are due annually on January 1
...

o Capital lease (financing lease)
▪ Lessor transfers substantially all the risks and benefits of ownership to the lessee
• Lessee “purchases” the asset
o Operating Lease
▪ Lessor transfers property rights to the lessee for a period of time
▪ Lessee returns property to lessor at the end of thte lease term
• Lessee “rents” the asset
o Criteria to Determine Lease Accounting Treatment
▪ Method of lease accounting is not a choice → it is dictated by the structure of the
lease
...

▪ Key issue → which party enjoys the economic benefits and bears the economic risks
of the lesae property
▪ A firm must account for a lease as a capital lease if the lease meets any one of the
following four conditions
• 1
...
A bargain purchase option exists (lessee has a right to buy the asset at
the end of the lease for less than market value
...
The lease term extends for at least 75% of the asset’s life
• 4
...

▪ At end of each year: Periodic rent expense
• Dr
...
Cash
▪ Future operating lease payments must be disclosed in footnotes
o Accounting for Lessee: Capital Lease
o

-

Page 29

Corporate Acquisitions: Class notes
▪

Inception: record an asset and a liability at the present value of the lease payments
• Dr
...
Capital Lease Liability
▪ At end of year: record depreciation expense and record cash payments as interest
expense and reduction in liability
• Dr
...
Accumulated Depreciation
•
• Dr
...
Capital Lease Liability (PLUG)
• Cr
...
Equipment
• Cr
...
Cash
• Cr
...
Depreciation Expense
• Cr
...
Lease Receivable
• Cr
...
COGS
• Cr
...
Cash
• Cr
...
Lease Receivable
•
SOUTHWEST CASE
- 1
...
Record the journal entry to reflect scheduled
payments during 2006 for operating and capital leases in place at the end of 2005
...

o Journal Entries
▪ Operating Lease
• Dr
...
Cash
332
▪ Capital Lease
• Dr
...
Lease Liability 11
• Cr
...
8%
- 2
...

o Still on Note 8
▪ Liability of a Capital Lease is the present value of future payments
▪ Obligation = 16/1
...
08^2 + 16/1
...
08^4 + 15/1
...
08^6
= 70
...

3
...

o D/E = Total liabilities/(Total Liabilities + Shareholder’s Equity) = Total Liabilities / Total
Assets
o
= 7,543/14,218 = 53%
4
...
If these agreements had been treated
as capital leases, what additional amount would be reported as a lease obligation on the balance sheet
at December 31, 2005? What would be the impact on Southwest’s debt-to-equity ratio computed in
question 3 above? Why may this type of analysis be useful in evaluating companies? The following
assumptions should be used to compute the present value of the minimum lease payments: 1) The
annual borrowing rate is 10%; Payments subsequent to 2010 ($1,164 million) are comprised of 5
annual payments of $233 million; and Lease payments are made annually on December 31
...

o Capitalize the Operating Lease Payments – Convert Existing Operating Lease
Commitments into Capital Leases
▪ Discount the Operating Lease Payments
▪ Year
Payment
Annuity Payment
Discount Factor PV
▪ 2006
332
332

...
8264
255
▪ 2008
274
274

...
6830
161
▪ 2010
219
219

...
79079 883

...

▪ New D/E Ratio = (7543+1608)/(14218+1608) = 58%
▪ This is an increase of about 10% just based on how the leases are structured
...


DEFERRED TAXES
- Introduction
o If you use LIFO for accounting, you must use it for taxes
...
This difference, and how
it is reconciled, gives rise to deferred taxes
...
e
...
g
...

• E
...
depreciation
o Book -- straight line for financial; Tax - MACRS
• Bad debt expense
o → Book – Allowance Method; Tax – Direct Write-off Method
Deferred Income Taxes
o Matching Principle says that tax expense recognized each period should be based on the
amount of book income regardless of the amount of taxes actually payable this period based
on taxable income
...

o Income tax Expense (also called Provision for Income Taxes)
▪ = (Book income before income taxes +/- permanent differences) * Statutory tax rate
o Income tax expense is comprised of a current component and a deferred component
▪ Current component reflects actual tax due
▪ Deferred component reflects tax associated with current period timing differences
between book and tax income
o Deferred tax assets and liabilities record the difference between tax payable to tax authorities
and the tax expense recorded in the income statement
▪ Dr
...
Deferred Tax Asset → these account for the differences
▪ Cr
...
Tax Payable
Deferred Tax Liabilities (DTL)
o DTL is something the company has not paid yet but will pay later
...
Therefore, they get a
liability until they pay the liability in the future
...
Almost like
Prepaid taxes
...

▪ Example: completed contract method
Deferred tax Assets and Liabilities
o Note: Assume no permanent differences
o Recording Deferred Tax Liabilities
▪

-

-

-

-

Page 32

Corporate Acquisitions: Class notes
▪
▪

From temporary differences that will result in future taxable income and thus, future
tax payments (e
...
book income = $250, IRS income = $225)
Journal Entry
• Dr
...
Income Taxes Payable
90
• Cr
...
According to its tax returns, what was Eastman Kodak’s total income tax obligation to all
governmental entities in the year 2000?
o Tax obligation → Tax Payable = 145 + 268 + 35 = 448
- 2
...
Income Tax Expense (Provision) 725
• Cr
...
Deferred Taxes (NET)
277
- 3
...
S
...
During the year ended December 31, 2000, which report included a greater amount of
depreciation expense: the tax return or the financial accounting income statement? What was the
magnitude of the difference?
o “During the year” → not cumulative → looking for the current period difference in timing
due to depreciation
o Note 10
▪ DTL regarding depreciation
▪ Change in DTL = Current Period Timing Difference * Tax Rate
• Change in DTL = 555 – 527 = 28
• Current Period Timing Difference = 28/
...
Therefore, liability is increasing making
the expense higher in the tax books because income is lower in tax books so
you paid less taxes and the liability therefore increases
...
Assume that the U
...
statutory tax rate of 35% was used to calculate deferred tax liabilities related to
depreciation
...
35
▪ Cumulative Timing Difference = 555/
...
Over the life of the total assets, they have recognized more
depreciation on the tax statement
...
What is the purpose of the valuation allowance which reduces the magnitude of deferred tax assets?
Which specific items(s) does the allowance relate to?
o What is the Valuation Allowance? The portion they don’t think they can use in the future
...
→ these go to the income statement even if you
haven’t sold it
...

o

▪

FINAL CLASS (SLIDE 6 – MARKETABLE SECURITIES
- 11
...
g
...

o Equity Method – accounting method used by investing firm
▪ Initial purchase (including goodwill) is recorded as an asset at acquisition cost
• Goodwill – excess of purchase price over market value of identifiable net
assets
▪ Each period, the investing firm recognizes net income equal to its proportionate
share of the net income of the investee firm
...

• Dr
...
Investment (why aren’t we crediting revenue like in minority passive?)
▪ Goodwill is tested each period for impairment
- Minority Active Investments: Illustration
o Suppose A invested in 30% of company B in Year 1
...

o Details of B
▪ MV of total assets at time of purchase: $2M…30% = 600k
▪ Net income for Yr 1: $500k → 30% = 150k
▪ Dividends declared During Yr 1 = 180k → 30% = 54000
▪ Company B had an internally developed patent with book value = 0; 30% of the
market value of the patent = $80k
...

o Amortization expense of patent = 80,000/10
- Minority Active Investment - Equity Method Illustration
o Dr
...
Investment in B
150k
o Cr
...
Cash
54k
o Cr
...
Amortization Expense
8k
o Cr
...

2) Create “minority interest” account in S/E of parent if the parent owns less
than 100%
3) Adjust the assets and liabilities of subsidiary to FMV
4) Create “goodwill” if the purchase price exceeded the fair market value of
the net assets of the subsidiary
5) Eliminate the intercompany transactions between the two firms
6) Add together the various accounts of both companies
...
What is the amount of net realized gains or losses relating to ‘Securities available for sale’ sold during
2005? What is the effect of these transactions on net income before taxes for 2005?
40M in net realized gains (cash flow statement and somewhere else)
9
...
You may
ignore the impact of taxes
...

Carrying value – exising book value
Purchases
Dr
...
Cash
Sales
Dr
...
Unrealized Gains
Cr
...
Realized gains

$28,634
$28,634

19,059
10 (PLUG)
19,029
40

Acquisition cost of goods sold securities book value – unrealized gain
Acquisition Cost = Book Value – Unrealized Gain = 19029 – 10 = 19019
Acquisition Cost = Proceeds - Realized gains = 19059 – 40 = 1919
10
...
What is the effect of these transactions on net
income before taxes for 2005?
Look at Note 5: Securities Available for Sale
Unrealized Gain or Loss Account
- Beginning Balance = 1438-39 =
1399
- Dr
...
Unrealized Gain/Loss for Securities on Hand 456 (plug)
- Ending Balance = 1041 – 108 =
933
- This has no effect on net income

Page 36

Corporate Acquisitions: Class notes
11
...
By what amount would total
stockholders’ equity differ at December 31, 2005?

Change in MV at EOY
Acquired Y1
+10
Y2
+20
Sold Y3
+30

Income Statement Effect
Trading Security
+10
+20
+30

Available for Sale
0
0
+60

We need to go from 60 to 30
...
Take out any unrealized gains or losses from prior years
...

Adjustments
1) Sold Securities - Eliminate net unrealized gains/losses
2) Securities on Hand – Include unrealized gains/losses in income

2005
-10
-456

Net Income before taxes would have been lower by $466 if the securities were classified as trading rather
than available for sale
...
It will be the same
...

Chapter 12: SHAREHOLDER’s EQUITY
- S/E is a residual interest, representing the SH’s claims on the assets of a firm in excess of the claims of
creditors
o Authorize Shares → total shares that can be issued at any time over the life of the company
o Issued Shares → # of shares issued at any point in time
o Outstanding Shares → Issued Shares – Treasury Shares
- Treasury Stock
o Shares of the firms stock that have been repurchased by the firm
o Why repurchase shares?
▪ To have on hand to give to employees exercising stock options
▪ May be the best use of excess cash
▪ As a takeover defense
▪ As a signal of undervaluation of shares
▪ Better way to repay S/Hs due to tax reasons (S/H can pay capital gains tax rate rather
than dividend rate)
▪ Way to boost “Earnings per Share”
o Accounting
▪ Treasury shares are reflected in S/Hs equity at their cost to the firm until reissued or
retired
▪ Treasury stock account thus has a debit balance (contra SE account)
- Treasury Stock – Illustration
o See slides
- Other Capital Transactions
o Employee Stock options
▪ Options give the holder the right to buy a certain number of shares in the future at a
stated exercise price
▪ Granted by the company to management and other employees
o Terminology
▪ Grant date – date option given to employees
▪ Exercise date – date the option is exercised by employee

Page 37

Corporate Acquisitions: Class notes
▪

-

Exercise price – per share price that stock may be purchased at by the employee
(Strike price)
▪ In-the-money – exercise price below current market price
▪ Out-of-the-money – exercise price above current market price
▪ Vesting period – period before the employee can exercise the option
o Compensation expense has to be recognized
▪ Compensation expense equal to FV of the options is recognized over the vesting
period
▪ SFAS 123R – compensation expense must be recorded
Employee Stock options: illustration
o 1000 shares with $5 par value at a price of $35
...
Market value on date
of grant
o Expense is total FV of options divided by the vesting period

PACIFIC SUNWEAR CASE
1
...
Treasury Stock
o Cr
...
Common Stock
49
o Dr
...
Treasury Stock

99346

Reclassified to Retained Earnings
o Dr Retained Earnings
64934
o Cr
...
01
2
...

At Grant
No Entry
Compensation Grants – During Vesting Period
Stock compensation = stock compensation expense
Dr
...
APIC – Options

6220
6220

Stock Option Exercises by Employees
o Dr
...
Common Stock
8
o Cr
...


Using information in the stock options activity chart in Note 10, compute the value of option
grants made during the year ended February 3, 2007
...
5 year period, what proportion of the total stock-based compensation expense recognized
in 2006 relates to options granted to employees in 2006?
o
o
o
o
o

# shares granted = 684,325
FV of options granted (weighted average) = 9
...
36 = 6,405,282
Compensation expense = Total FV of Options Granted / Vesting Period = 6,405,282/3
...


EXAM
- Compensation Expense
- Treasury Stock
Stuff Covered Post Mid-term
- Long-lived assets
o Capitalize(create an asset) vs
...
Capital
▪ Four tests to determine if lease is a capital lease
o Operating Lease
▪ Record rent expense every period
o Capital lesae
▪ Record lease liability and asset on signing
▪ Record interest expense and amortization expense every period
• Dr
...
Lease Liability

Page 39

Corporate Acquisitions: Class notes
•
•

-

-

-

-

-

Cr
...
when it goes up Cr
...

Summing it all up
o Double entry bookkeeping
o Financial statements
o Knowledge of main asset, liability and SE accounts
o Notes to the financial statements
Uncovered topics
o Pensions
o Derivatives

Page 40

Corporate Acquisitions: Class notes
o
o

Consolidation (in depth)
▪ Take 30116 and 30117
USING financial statements
▪ Financial statement analysis
▪ Valuation
• Take 30130

Page 41



---