Review of Accounting Chapter 4

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Review ofAccounting

Feb 3Feb 3rdrd, 2010, 2010

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Learning Learning Objectives:Objectives:Use of the balance sheet, the Use of the balance sheet, the

income statement, and the income statement, and the statement of cash flows by statement of cash flows by managers.managers.

Calculation of depreciation.Calculation of depreciation.How depreciation affects cash flow.How depreciation affects cash flow.Calculation of marginal and Calculation of marginal and

average tax rates. How taxes average tax rates. How taxes affect cash flow.affect cash flow.

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The Firm’s Financial The Firm’s Financial StatementsStatements

Annual report includes:Annual report includes:

Link to Annual Report Gallery

Balance sheetBalance sheet Income statementIncome statementStatement of cash flowsStatement of cash flowsStatement of Retained EarningsStatement of Retained EarningsAccompanying notesAccompanying notes

http://www.reportgallery.com/

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Current LiabilitiesA/PPayrollS-T Debt

Long Term LiabilitiesL-T Bank DebtBondsMortgages

Assets = Liabilities + Owners’ EquityAssets = Liabilities + Owners’ Equity


Current AssetsCashA/RInventory

Fixed AssetsLandBuildingsEquipment Less:

Accum. Dep.

Balance Sheet (Balance Sheet (as of a point in timeas of a point in time))

Owners’ Equity Preferred Stock

Common StockCapital in Excess

of ParRetained Earnings

Balance Balance SheetSheet ACME CORPORATIONACME CORPORATION

Assets: 2001 2002 Change

Cash $9,000,000 $10,000,000 1,000,000

Accounts receivable 700,000 $1,000,000 300,000

Inventory 17,300,000 $10,000,000 -7,300,000

Marketable Securities 9,000,000 $8,000,000 -1,000,000

Prepaid Expenses 1,000,000 $1,000,000 0

Total current assets 37,000,000 $30,000,000 -7,000,000

Fixed Assets, Gross 14,000,000 $28,000,000 14,000,000

less Accumulated Depr. (6,000,000) ($8,000,000) -2,000,000

Fixed Assets, Net 8,000,000 $20,000,000 12,000,000

Total assets $45,000,000 $50,000,000 5,000,000

Year Ended December 31Year Ended December 31

Balance Balance SheetSheet

ACME CORPORATIONACME CORPORATION

2001 2002 ChangeAssets:

Cash $9,000,000 $10,000,000 1,000,000Accounts receivable 700,000 1,000,000 300,000Inventory 17,300,000 10,000,000 -7,300,000Marketable Securities 9,000,000 8,000,000 -1,000,000Prepaid Expenses 1,000,000 1,000,000 0 Total current assets 37,000,000 30,000,000 -7,000,000Fixed Assets, Gross 14,000,000 28,000,000 14,000,000 less Accumulated Depr. (6,000,000) (8,000,000) -2,000,000 Fixed Assets, Net 8,000,000 20,000,000 12,000,000

Total assets $45,000,000 $50,000,000 5,000,000

2001 2002 Change

Liabilities & Equity:

Accounts Payable $7,000,000 $4,000,000 -3,000,000Notes payable 4,000,000 3,000,000 -1,000,000Accrued Expenses 3,000,000 2,000,000 -1,000,000Total current liabilities 14,000,000 9,000,000 -5,000,000 Long-term debt 10,784,000 15,000,000 4,216,000Total liabilities 24,784,000 24,000,000 -784,000Preferred Stock 2,000,000 1,000,000 -1,000,000Common stock 1,000,000 3,000,000 2,000,000Capital in Excess of Par 10,000,000 12,000,000 2,000,000Retained earnings 7,216,000 10,000,000 2,784,000Total common equity 18,216,000 25,000,000 6,784,000Total equity 20,216,000 26,000,000 5,784,000

Total liabilities & equity $45,000,000 $50,000,000 5,000,000

Year Ended December 31

Assets = Liabilities + Owner’s EquityAssets = Liabilities + Owner’s Equity

Balance Balance SheetSheet

ACME CORPORATIONACME CORPORATIONYear Ended December 31

2001 2002 Change

Liabilities & Equity:

Accounts Payable $7,000,000 $4,000,000 -3,000,000Notes payable 4,000,000 3,000,000 -1,000,000Accrued Expenses 3,000,000 2,000,000 -1,000,000Total current liabilities 14,000,000 9,000,000 -5,000,000 Long-term debt 10,784,000 15,000,000 4,216,000Total liabilities 24,784,000 24,000,000 -784,000Preferred Stock 2,000,000 1,000,000 -1,000,000Common stock 1,000,000 3,000,000 2,000,000Capital in Excess of Par 10,000,000 12,000,000 2,000,000Retained earnings 7,216,000 10,000,000 2,784,000Total common equity 18,216,000 25,000,000 6,784,000Total equity 20,216,000 26,000,000 5,784,000

Total liabilities & equity $45,000,000 $50,000,000 5,000,000

2001 2002 ChangeAssets:

Cash $9,000,000 $10,000,000 1,000,000Accounts receivable 700,000 1,000,000 300,000Inventory 17,300,000 10,000,000 -7,300,000Marketable Securities 9,000,000 8,000,000 -1,000,000Prepaid Expenses 1,000,000 1,000,000 0 Total current assets 37,000,000 30,000,000 -7,000,000Fixed Assets, Gross 14,000,000 28,000,000 14,000,000 less Accumulated Depr. (6,000,000) (8,000,000) -2,000,000 Fixed Assets, Net 8,000,000 20,000,000 12,000,000

Total assets $45,000,000 $50,000,000 5,000,000

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Balance sheetBalance sheet Income statementIncome statementStatement of cash flowsStatement of cash flowsAccompanying notesAccompanying notes

http://www.reportgallery.com/

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Revenues - Expenses = Net IncomeRevenues - Expenses = Net Income

Sales

Income Statement (Income Statement (covers a period of covers a period of timetime))

Cost of MaterialsDirect laborManufacturing overhead, including DepreciationMarketing ExpResearch & DevelopmentAdministrative ExpTaxesInterest Exp.

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RetainedRetained EarningsEarnings


Revenues - Expenses = Net IncomeRevenues - Expenses = Net Income

Income Income Statement Statement

DividendsDividendsNote: Dividends are paid out ofNote: Dividends are paid out of

retained earnings, not net incomeretained earnings, not net income

Income Income StatementStatement

ACME CORPORATIONACME CORPORATION

Net Sales $15,000,000Cost of goods sold (Mat'l, Labor, OH) 5,000,000Gross profit (margin) 10,000,000Depreciation 2,000,000Selling & Admin Expenses 800,000Operating Income (EBIT) 7,200,000Interest expense 1,710,000Income before taxes 5,490,000Income taxes (40%) 2,196,000

Net income $3,294,000

For the Year Ended December 31, 2002

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Ethical Considerations - Ethical Considerations - IncomeIncome

Rite Aid investigated by the SECRite Aid investigated by the SEC $500 million restatement of $500 million restatement of

earningsearnings KPMG resigned as auditor because KPMG resigned as auditor because

they were unable to rely on they were unable to rely on management’s representationsmanagement’s representations

Stock fell by 86%!Stock fell by 86%! Firm (investors!) lost $11.2 billion Firm (investors!) lost $11.2 billion

in market valuein market value See page 53 (72) for detailsSee page 53 (72) for details

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Balance sheetBalance sheet Income statementIncome statementStatement of cash flowsStatement of cash flowsAccompanying notesAccompanying notes

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Statement of Cash FlowsStatement of Cash Flows

Reconciles net income and change in cashReconciles net income and change in cash Broken down into 3 sections:Broken down into 3 sections:

Cash flow from operationsCash flow from operationsCash flow used for investingCash flow used for investingCash flow from/for financingCash flow from/for financingThe total of these 3 = change in cashThe total of these 3 = change in cash

Balance Sheet current year cash balance Balance Sheet current year cash balance minus prior year cash balance = change in minus prior year cash balance = change in cashcash

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How balance sheet changes affect cash How balance sheet changes affect cash flowflow

Decision Table:Decision Table:

Asset increasesAsset increases (-) Use of (-) Use of cashcash

Asset decreasesAsset decreases (+) Source of (+) Source of cashcash

Liability increasesLiability increases (+) Source of (+) Source of cashcash

Liability decreasesLiability decreases (-) Use of cash(-) Use of cash

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Cash Inflow - Cash Outflow = Change in CashCash Inflow - Cash Outflow = Change in Cash

Net Income+Depreciation & amortization (non-cash expenses)-Increase/+Decrease in Current Assets (+/- cash)+Increase/-Decrease in Current Liabilities (+/- cash)= cash from operations (can be + or -), but usually a

source of cash (+) (EBITDA)See Fig 4-4, page 58 (77)

From Operations:From Operations:

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+Sale of Fixed Assets -Purchase of fixed assets+Sale of Securities -Purchase of Securities+Sale of other LT assets -Purchase of other LT assets

= cash used for investing (usually a use of cash)

See Fig 4-4, page 58 (77)

From Investing:From Investing:

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+Sale of stock -Buy back stock+Issue of LT debt -Repay LT debt or notes payable -Pay dividends

= cash received from or used for Financing

See Fig 4-4, page 58 (77)




From Financing:From Financing:

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SummarySummary

Cash flow from operationsCash flow from operations 9,2949,294

-/+ cash flow from investing-/+ cash flow from investing - -14,00014,000

+/- cash flow from financing+/- cash flow from financing5,7065,706

= change in cash= change in cash 1,000

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Statement of Cash flow - Statement of Cash flow - AcmeAcme Figure 4-4, page 58 (77)Figure 4-4, page 58 (77)

Statement of cash flowStatement of cash flow Figure 4-5, page 59 (78)Figure 4-5, page 59 (78)

Statement of changes on balance Statement of changes on balance sheetsheet

Compare, trace change column on Compare, trace change column on balance sheet to cash flow balance sheet to cash flow statementstatement

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Ethical Considerations - Ethical Considerations - EnronEnron Failure of Failure of managementmanagement team for errors team for errors

on financial statements and hidden debt on financial statements and hidden debt Failure of Failure of analystsanalysts and and debtdebt ratingrating

agenciesagencies to forewarn investors to forewarn investors InvestmentInvestment bankersbankers and and attorneysattorneys who who

created the special purpose entitiescreated the special purpose entities Failure of Failure of audit firmaudit firm due to conflict of due to conflict of

interest – audit versus consultinginterest – audit versus consulting Retirement planRetirement plan administratorsadministrators who put who put

employee contributions into Enron stockemployee contributions into Enron stock

(See page 61 (80) for details) (See page 61 (80) for details)

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DepreciationDepreciation Accounting depreciation is the allocation of an Accounting depreciation is the allocation of an

asset’s initial cost over time.asset’s initial cost over time. Book value is Asset Cost minus DepreciationBook value is Asset Cost minus Depreciation Book Value does not equal Market Value Book Value does not equal Market Value

Allowable depreciation expense is determined Allowable depreciation expense is determined by accounting rules.by accounting rules.

Depreciation is a Depreciation is a non-cash expensenon-cash expense

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Calculation of Calculation of DepreciationDepreciation

Straight line depreciation –used per booksStraight line depreciation –used per books Depreciable basis divided by accounting life Depreciable basis divided by accounting life

with equal amounts of depreciation allocated with equal amounts of depreciation allocated to each time period.to each time period.

Depreciable basisDepreciable basisTotal amount to be depreciated over the Total amount to be depreciated over the

accounting life of the asset.accounting life of the asset.Equal to cost of the asset plus any Equal to cost of the asset plus any

installation, setup and delivery costs incurred.installation, setup and delivery costs incurred.

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Example of Straight Line Example of Straight Line DepreciationDepreciation

Total depreciable basis =$10,000Total depreciable basis =$10,000 Accounting life = 3 yearsAccounting life = 3 years YearYear PercentPercent BasisBasis

AmountAmount 11 33.3333.33 $10,000$10,000 $3,333$3,333 22 33.3333.33 $3,333$3,333 33 33.3433.34 $3,334$3,334

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Federal Income TaxationFederal Income Taxation Tax ComputationTax Computation

2002 Corporate Tax Rates

Taxable IncomeTaxable Income Tax RateTax Rate$0 - $50,000 15%$50,001 - $75,000 25%$75,001 - $100,000 34%$100,001-$335,000 39%$335,001-$10,000,000 34%$10,000,001-$15,000,000 35%$15,000,001-$18,333,333 38%Over $18,333,333 35

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Tax Calculation ExampleTax Calculation Example

Taxable income = $1,000,000Taxable income = $1,000,000 $ 50,000$ 50,000xx .15 = $ 7,500.15 = $ 7,500 $ 25,000$ 25,000xx .25 = $ 6,250.25 = $ 6,250 $ 25,000$ 25,000xx .34 = $ 8,500.34 = $ 8,500 $ 235,000$ 235,000 xx .39 = $ 91,650.39 = $ 91,650 $ $ 665,000665,000 xx .34 = .34 = $226,100

$1,000,000$1,000,000 TaxTax $340,000$340,000

Note: 34% of $1,000,000 = ?

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Marginal tax rate = tax rate on next dollar earned= 15 % on income from 0 – 50,000= 39% on income from $100,000 to $335,000Above $335,000, to $10,000,000 marginal rate = 34%, Above $18,333,333, marginal rate = 35%

Federal Income TaxationFederal Income Taxation

Used in computing after tax Used in computing after tax cash flow for calculation of cash flow for calculation of value of business decisionsvalue of business decisions

Marginal Tax Marginal Tax RateRate

2002 Corporate Tax Rates2002 Corporate Tax Rates

Taxable IncomeTaxable Income

Tax Rate Tax Rate

$0 - $50,000

15%$50,001 - $75,000

25%$75,001 - $100,000

34%$100,001-$335,000

39%$335,001-$10,000,000 34%

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End of Chapter 4End of Chapter 4

Taxes – Ugh!Taxes – Ugh!

Review of Accounting Chapter 4

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