Introduction to

Financial Accounting

Pre-Class Material

Copyright 2009 Investment Banking Institute

www.ibtraining.com
Table of Contents

I. Introduction to Accounting

II. Balance Sheet Overview

III. Income Statement Overview

IV. Cash Flow Statement Overview

V. Advanced Topics

2
Introduction

What is accounting?
Accounting is the language of business
Three main types of accounting
Financial accounting How financial information of a business is recorded
and classified (i.e. financial statements of public companies)
Managerial accounting Typically used within an organization by
management for planning and decision making
Tax accounting Branch of accounting used to comply with jurisdictional
tax regulations
In this class will be concerned exclusively with financial accounting
All developed countries have standards of financial accounting or
Generally Accepted Accounting Principles (GAAP)
GAAP includes the standards, conventions and rules that accountants
follow when recording and summarizing transactions and in the
preparation of financial statements
In the United States, the organization whose primary purpose is to
develop these generally accepted accounting principles is the Financial
Accounting Standards Board (FASB).
FASB is a private-sector organization, not a government body

3
Introduction

The FASB has articulated the key objectives of financial

reporting. Specifically, financial reporting should provide
useful information:
For making rational investment and credit decisions
To help investors and creditors assess the amount, timing and
uncertainty of future cash flows
About the economic resources of a firm and the claims on those
resources
About a firms operating performance during a period
About how an enterprise obtains and uses cash
About how management has discharged its stewardship
responsibility to owners (i.e. how management prudently uses the
firms resources)
That includes explanations and interpretations to help users
understand the financial information provided

4
Introduction

In the United States, public companies are required by the

government (SEC) to release their financial statements to the
public four times per year
Once a year, companies release a 10-K or annual report that
must be audited by an accounting firm
For the three other quarters, companies release a 10-Q or
quarterly report that is unaudited
Substantially all medium to large private companies and many
small private businesses also prepare annual and quarterly
financial statements as they are often required by lenders and
investors.
However, these statements are only made available to the public
if the company has publicly traded securities (i.e. debt)

5
Table of Contents

I. Introduction to Accounting

II. Balance Sheet Overview

III. Income Statement Overview

IV. Cash Flow Statement Overview

V. Advanced Topics

6
Balance Sheet Overview

The balance sheet presents the financial position of a firm at a

particular moment in time
The balance sheet contains three main sections: assets,
liabilities and shareholders equity
Assets are economic resources with the ability or potential to
provide future benefits to the firm
Liabilities are creditors claims on the assets of the firm
Shareholders equity is the owners claim on the assets of the firm
The basic equation of the balance sheet is:
Assets = Liabilities + Shareholders equity
This equation must always hold true (hence the name BALANCE
sheet)!

7
Assets

Recognition of assets:
A firm will recognize an asset only if (1) the firm has acquired rights to its
use in the future as a result of a past transaction or exchange and (2) the
firm can measure or quantify the future benefits with a reasonable degree
of precision
While all assets represent future benefits, not all future benefits are
assets
Valuation of assets:
Accountants must assign a monetary amount to each asset in the balance
sheet. Several methods can be used to assign value:
Acquisition or Historical Cost represents the amount of cash (or cash
equivalent) paid in acquiring the asset
Current Replacement Cost represents the amount currently required to acquire
the asset
Current Net Realizable Value represents the amount of cash that a firm would
receive if it sold the asset (less the cost involved to sell the asset)
Present Value of Future Net Cash Flows represents the future benefits of the
asset discounted to the current period by an appropriate discount rate

8
Assets

Valuation of Assets (continued):

Generally Accepted Accounting Principles (GAAP) stipulate which
valuation method to use depending on the type of asset
Monetary assets such as cash and accounts receivable generally
appear on the balance sheet at their net present value (i.e. their
current cash or cash equivalent value)
Cash appears as the amount of cash on hand or in the bank
Accounts receivables appear as the amount of cash the firm expects to
receive but undiscounted since the firm expects to receive payment in
a short period of time (e.g. days to several months)
Non-monetary assets such as inventory, equipment, building and
land appear at acquisition cost (less accumulated depreciation
value which will be discussed later)

9
Assets

Assets are typically divided into two categories: current assets

and noncurrent assets (or long-term assets)
Current assets include assets that the firm expects to turn into
cash, sell or consume within one year. Examples of current
assets include:
Cash and cash equivalents
Temporary investments in securities
Accounts receivable from customers
Merchandise Inventories, which includes:
raw materials
supplies
work-in-progress
finished goods
Prepaid operating costs such as prepaid rent or insurance

10
Assets

Noncurrent or long-term assets are assets that the firm expects

to hold or use for longer than one year. Common noncurrent
assets include:
Long-term investments in securities
Property, Plant and Equipment (PP&E) also called fixed assets
including:
Land
Buildings
Machinery
Equipment
Computers
Furniture and Fixtures
Intangible Assets, such as:
Patents
Trademarks
Franchises
Goodwill

11
Liabilities

Liability recognition
A liability is recognized when the firm receives a benefit or service and in
exchange, promises to pay the provider of that good or service a
reasonably definite amount in a reasonably definite time
Similar to the discussion of assets, all liabilities are obligations but not all
obligations are liabilities
Valuation of liabilities
Liabilities that require payments of specific amounts of cash due in less
than one year appear on the balance sheet at the amount of cash the firm
expects to pay to discharge the obligation
Obligations that require specific amounts of cash due in more than one
year appear at the present value of the future cash outflows
Liabilities that require delivery of goods or providing services rather than
cash can appear on the balance sheet either at the cost of providing the
goods or service, or at the cash amount received for providing the future
goods or services (depending on circumstances). For example:
Liability for a product warranty for goods already sold appears at the expected
cost of providing the warranty
Liability for advance payment for goods to be sold appear as the amount of cash
received

12
Liabilities

As with assets, liabilities are also typically divided into two

categories: current liabilities and noncurrent liabilities (or
long-term liabilities)
Current liabilities represent obligations a firm expects to pay
within one year. Examples of current liabilities include:
Notes payable to banks
Accounts payable to supplies
Salaries payable to employees
Taxes payable to governments
Noncurrent or long-term liabilities are liabilities that the firm
expects to pay beyond one year. Common noncurrent
liabilities include:
Debt due or having maturities in more than one year (such as
bonds, mortgages and certain long-term leases)
Other long-term liabilities can include deferred income taxes and
certain retirement obligations

13
Working Capital

While not its own balance sheet item, working capital is a key
concept that is derived from the balance sheet as well as an
important measure of firms short-term financial health
Working capital is also sometimes referred to as net working
capital
Working capital equals a firms current operating assets less its
current operating liabilities
Current operating assets = current assets cash and cash
equivalents
Current operating liabilities = current liabilities short-term debt

14
Shareholders equity

Shareholders equity is generally made up of two types:

contributed capital and retained earnings
Contributed capital reflects the funds invested by shareholders
for an ownership stake. Contributed capital includes:
Par value of common or preferred stock: the amount (usually a
nominal amount) assigned to the common or preferred stock. Note:
Par value does not equal the market value of the stock
Additional Paid-in Capital: in the issuance of common or preferred
stock, the amount received by the firm in excess of par value
Retained earnings represents a firms earnings since its formation
less the dividends paid out to the firms owners since formation
Retained earnings can often be negative, especially for a new
company that loses money in its first few years of operation
In addition, if a firm acquires or buys back shares originally
issued, the cost of those shares is classified on the balance sheet
as Treasury Shares or Treasury Stock

15
Balance Sheet Example

($ in millions) December 31,

2004 2005
Assets
Current Assets:
Cash and cash equivalents $437.9 $224.0
Accounts and notes receivable 241.0 309.4
Inventories 1,003.7 964.9
Other current assets 92.5 129.0
Total current assets 1,775.1 1,627.3
Property plant and equipment, net 652.0 476.2
Other assets, net 89.6 101.6
Total assets $2,516.7 $2,205.1
Liabilities and Stockholders' Equity
Current liabilities:
Short-term debt $55.6 $40.9
Accounts payable 442.2 490.9
Accrued expenses and other current liabilities 342.1 379.5
Income taxes payable 117.5 75.0
Total current liabilities 957.4 986.3
Long-term debt 506.9 494.9
Other non-current liabilities 130.3 135.1
Total liabilities 1,594.6 1,616.3
Stockholders' equity:
Common stock 191.0 191.0
Additional paid-in capital 82.7 88.2
Retained earnings 1,507.8 1,741.2
Treasury stock (859.4) (1,431.6)
Total stockholders' equity 922.1 588.8
Total liabilties and stockholders' equity $2,516.7 $2,205.1

16
Table of Contents

I. Introduction to Accounting

II. Balance Sheet Overview

III. Income Statement Overview

IV. Cash Flow Statement Overview

V. Advanced Topics

17
Income Statement Overview

The income statement presents the results of the operating

activities of a firm for a specific period of time (i.e. one year,
one quarter, etc.)
The basic equation of the income statement is total revenues
(also called sales or the top line) less total expenses (or
costs) equals net income (or earnings or the bottom line)
Revenues measure the inflows of assets (or reductions in
liabilities) from selling goods and services
Expenses measure the outflow of assets (or increases in liabilities)
used in generating revenues
Net income is the difference between revenues and expenses
(positive if the firm made a profit and negative if the firm made a
loss)

18
Cash vs. Accrual Accounting

There are two accounting approaches that a firm can use to measure
operating performance: (1) cash basis or (2) accrual basis
Cash basis of accounting
Under the cash basis, a firm recognizes revenue from selling goods or
providing services in the period when it received cash from customers
Similarly, the firm recognizes expenses in the period when it makes cash
expenditures (i.e. pays) for merchandise, salaries, taxes, etc.
Disadvantages of cash basis accounting
The cost of generating revenues are not adequately matched with the
benefits of generating revenues.
For example, if inventory is purchased at the end of a year, and that inventory is
sold to customers at the beginning of the following year, the firms income
statement will show an expense (but no revenue) the first year and revenue (but
no expense) the following year
This mismatch makes it difficult to compare operational performance from
one year to the next

19
Cash vs. Accrual Accounting

Disadvantages of cash basis accounting (continued)

Revenue recognition can be significantly delayed
The firm does not book revenues when goods are sold or services provided but
when payment is received for those goods or services
Again, this can cause a timing mismatch from the difficult work of
manufacturing and selling goods or providing services, and the recognition of
revenues
Operating performance can be easily manipulated
Because expenses are recognized only when cash expenditure is made, firms
have the ability to time payments in order to manipulate profits. For example,
firms can delay payments until the next fiscal year in order to show a higher
profit for the current year
Advantages of cash basis accounting
Bookkeeping is easier since only cash inflows and outflows need be
recognized and accounted for
For firms with no inventories, few multi-period assets (such as buildings or
equipment) and who usually receive payment for services shortly after
providing services (e.g. professionals such as lawyers and accountants),
cash basis accounting can be suitable

20
Cash vs. Accrual Accounting

Accrual basis of accounting

Most firms, including all public firms, use the accrual basis of
accounting
The accrual basis recognizes revenue when a firm sells goods or
provides services
The costs of assets used in producing the goods that were sold are
recognized in the same period from which the associated revenue
is recognized
The key factor (and advantage) of accrual accounting is that expenses
are matched with associated revenues
If the cost of assets used do not easily match up with particular
revenues, then the expenses appear in the period in which the assets
are used
An added benefit of the accrual method is that there are fewer
opportunities for the firm to distort or manipulate earnings
All of the analysis performed in this class will assume the accrual
basis of accounting

21
Revenue

Revenue recognition
Under accrual accounting, revenue is recognized when the following two
conditions have been met:
A firm has performed all or most of the services it expects to provide
The firm has received cash or another asset (such as a receivable) capable of
measuring (reasonably precisely) the revenue to be recognized
Adjustments to revenue
If a firm recognizes revenue in a period before it collects cash, it may
need to make adjustments to the agreed upon price. These adjustments
are made at the same time (or same period) as the revenue is recognized.
Such adjustments include:
Uncollectible amounts or bad debts: the firm does not expect to collect the
entire amount
Sales discounts, allowances or returns: discounts off the purchase price or
allowances for unsatisfactory merchandise or services or returned goods
Delayed payments: payments longer than one-year from delivery of the goods or
services require the revenue to be reduced by an implied interest charge
Gross revenue net of any adjustments is referred to as Net Revenue
Usually, only net revenue will be reported on a firms income statement
but sometimes gross revenue and adjustments will also be shown

22
Expenses

Expense recognition
Under accrual accounting, expenses are recognized as follows:
If an asset expiration (e.g. using inventory) can be associated directly
with a particular revenue, that expiration becomes an expense when
the firm recognizes revenue
9 This is knows as the matching principle. Costs are matched with revenues
If an asset expiration does not clearly associate with particular
revenue, then that asset expiration becomes an expense in the period
when the firm consumes or uses the benefit of that asset
Costs that can be easily matched to revenues are known as direct
costs or Cost of Goods Sold or COGS (also called cost or sales,
cost of revenue, cost of product). Examples include:
Cost of materials that comprise the goods being sold
Cost of labor directly responsible for making the goods being sold
On the income statement, net revenues less COGS equals Gross
Profit (also called Gross Margin)

23
Expenses

Costs that cannot be directly matched to revenue are known as

indirect costs. The largest category of indirect costs that almost
always appears on an income statement is Selling, General and
Administrative costs (SG&A)
SG&A is typically comprised of costs such as:
Marketing and advertising
Salaries of management
Office expenses
Travel and entertainment
Professional services such as legal and accounting
Other indirect operating expenses may include research and
development, depreciation (see the following page) as well as non-
recurring or restructuring expenses
Gross Profit less SG&A and other indirect operating expenses equals
Operating Income or EBIT (Earnings Before Interest and Taxes).
EBIT represents the profits of the companys operations or equivalently,
the profits of the company before taking out interest and taxes

24
Depreciation Expense

One additional and significant operating cost that has not been
mentioned yet is depreciation
Accrual accounting stipulates that when assets such as factories and
equipment are purchased, rather than have the entire amount
expensed through the income statement when the property is
purchased, the property gets depreciated over time
Because the asset will be used for a future benefit (e.g. used to generate
future revenues), the cost of depreciating the asset is accountings
attempt to match the benefit of the asset with the cost of the asset
The periodic (e.g. annual) cost of depreciating the assets becomes a cost
on the income statement
Depreciation is a process of cost allocation, and NOT meant to measure
the decline in value of the asset
There are various methods of depreciating assets (i.e. straight-line,
accelerated) and because different assets have different useful lives, they
can be depreciated over differing time periods
Land is not typically depreciated as it does not have a finite life

25
Depreciation Expense

The cost of depreciation can be considered a direct cost (Cost of

Goods) or an indirect cost (SG&A or other expense) depending on the
type of asset and the type of company. For example:
A manufacturing company that owns machinery that produces goods,
would consider the depreciation of that machinery a part of COGS
That same manufacturing company which also owns the building for its
corporate headquarters, would consider the depreciation of the
headquarters building as an indirect cost (SG&A)
Depreciation (and amortization) is sometimes listed separately on the
income statement as an operating expense but rarely broken out from
COGS
The only way to ensure that the entire amount of depreciation and
amortization is known, is to consult the cash flow statement
Amortization is similar to depreciation but is used for expensing over
time intangible assets rather than tangible assets such as property
and equipment

26
Interest and Other Income

Interest expense and interest income are shown below the

operating income or EBIT line on the income statement
Sometimes interest expense and interest income are shown
separately and sometimes only the net interest expense (interest
expense less interest income) is shown
Interest expense and interest income are not considered
operating expenses or operating income for most companies
(banks and other financial institutions are an exception) because
the amount of interest expense is dependant on the amount of
debt which is primarily a financing, rather than operational
decision
Operating income (EBIT) less net interest expense equals
Earnings Before Taxes (EBT)
Occasionally, an income statement will also list non-operating
income. This will come below operating income (typically below
net interest expense) and before the line for taxes

27
Taxes and Net Income

The income statement will also have a line item for taxes
(often called Provision for income taxes).
This represents the income taxes that the company owes based on
financial accounting (book basis) but not necessarily the amount
that will actually be paid to the government (see Advanced Topics
for more information)
In the United States, the statutory rate for income taxes is 35%
but the actual tax that a firm pays can vary significantly
depending on many factors including state taxes, foreign taxes,
previous operations and tax treatments (e.g. Net Operating
Losses), etc.
Earnings Before Taxes (EBT) less the Income Tax Provision
equals Net Income (also called Net Earnings or the bottom
line)

28
Net Income and EPS

On a public companys income statement, Earnings Per Share

(EPS) is typically listed directly below net income
Earnings per share is the net income of the company divided by
the number of common shares outstanding
Usually two different metrics of earnings per share are shown:
basic and diluted
Basic earnings per share equals net income divided by the number
of common shares currently outstanding
Diluted earnings equals the same net income divided by the
number of common shares outstanding taking into account the
effects of any company issued stock options outstanding
Stock options, when exercised have the effect of diluting the common
ownership because new shares must be issued. That is, more shares
(or more owners) have ownership stake or claims on the same net
income
Diluted shares are always greater than basic shares so diluted EPS is
always less than basic EPS (assuming at least one option is exercisable
and in-the-money)

29
Income Statement Example

($ in millions) Fiscal Year Ending December 31,

2003 2004 2005

Net sales $4,649.3 $4,841.2 $5,081.7

Cost of goods sold (COGS) 2,333.6 2,406.7 2,706.3
Gross profit 2,315.7 2,434.5 2,375.4
Selling, general and administrative 1,740.0 1,774.8 1,901.7
Operating income (EBIT) 575.7 659.7 473.7
Net interest expense (35.7) (29.6) (44.5)
Income before income taxes (EBT) 540.0 630.1 429.2
Provision for income taxes 174.3 204.9 51.6
Net income $365.7 $425.2 $377.6

30
Table of Contents

I. Introduction to Accounting

II. Balance Sheet Overview

III. Income Statement Overview

IV. Cash Flow Statement Overview

V. Advanced Topics

31
Cash Flow Statement Overview

The statement of cash flows reports the net cash flows relating to
operating, investing and financing activities for a period of time (the
same period of time as the income statement)
Due to accrual accounting, the income statement does not measure
cash inflows and outflows. However, since cash is so important
(cash is king), the cash flow statement is a very important tool for
understanding the operations of the company
The basic equation of the cash flow statement is: cash at the
beginning period + cash from operations + cash from investing + cash
from financing = cash at the end of period
The cash flow statement is divided into three categories:
Cash from operations equals cash received from selling goods and
services less cash paid for providing goods and services
Cash from investing equals cash received from sales of investments and
PP&E less cash paid for the acquisition of investments and PP&E
Cash from financing equals cash received from the issue of debt or equity
less cash paid for dividends and the reacquisition of debt or equity

32
Cash Flow Statement Overview

In theory, firms could prepare their cash flow statements by

accounting for each and every cash inflow and outflow, however, this
would be burdensome
The simpler way to prepare a cash flow statement is examine the
balance sheet for changes in assets, liabilities and shareholders
equity from the beginning of the period to the end of the period
That is, the change to the value of any item on the balance sheet must
have a corresponding cash impact (and must be accounted for somewhere
in the cash flow statement).
An increase in assets on the balance sheet MUST correspond to a
decrease in cash on the cash flow statement
For example, other things equal, an increase in PP&E (asset) on the balance
sheet results in decrease in cash as cash is used to purchase the new equipment
An increase in liabilities and shareholders equity on the balance sheet
MUST correspond to an increase in cash on the cash flow statement
For example, other things equal, an increase in debt (liability) on the balance
sheet (i.e. a new bank loan) results in an increase in cash

33
Cash Flow from Operations

Most firms report cash flow from operations using the indirect
method
In the indirect method, cash flow from operations is the result of
adjusting net income for non-cash items
An alternative, but less frequently used method is the direct
method whereby cash flow from operations lists the cash
received from customers and the cash expenditures to suppliers
This difference between the two methods is purely presentation
numerically they will give the same result
Under the indirect method, the first line in this section is net
income
Typically, the next line is depreciation and amortization (D&A)
While D&A does not provide cash, it must be added back in the
cash flow statement since it was included in net income (as an
expense).
D&A will have a positive sign on the cash flow statement

34
Cash Flow from Operations

Then adjust for changes in operating assets (i.e. working capital). For
example:
Change in accounts receivable (asset)
Change in inventories (asset)
Change in other current assets (asset)
Change in accounts payable (liability)
Change in accrued expenses (liability)
Change in other current liabilities (liability)
Remember, an increase in assets is a negative cash impact or use of
cash while an increase in liabilities is a positive cash impact or
source of cash
Be mindful of the signs (positive/negative): an increase in assets will
have a negative sign and an increase in liabilities will have a positive sign
(and vice versa for decreases)
Summing up net income, D&A, changes in working capital and changes
in other operating items results in Cash Flow from Operations

35
Cash Flow from Investing

Cash flow from Investing takes into account acquisitions and

sales of investments and property, plant and equipment
(PP&E)
The first line item in this section is usually additions to PP&E
(commonly referred to as capital expenditures or capex)
Capex is a use of cash and will have a negative sign
The next line item(s) is typically proceeds form any sales of PP&E
Proceeds from the sale of PP&E is a source of cash and will have a
positive sign
Finally, the acquisition of or proceeds from the sale of any other
investments is listed
The sum of capex (negative), proceeds from the sale of PP&E
(positive) and net investment activity (negative) results in Cash
Flow from Investing

36
Cash Flow from Financing

Cash flow from Financing takes into account changes to a firms debt
and equity positions. Line items in this section include:
Increase/decrease in short-term borrowings or short-term debt
Increase/decrease in long-term borrowings or long-term debt
Payments of dividends
Issue of capital stock (i.e. common stock, preferred stock)
Purchase of treasury stock (decrease of capital stock)
Other financing transactions
Again, increases in liabilities and shareholders equity (e.g. increase
in borrowings) will have a positive sign and decreases will have a
negative sign (e.g. purchase of treasury stock)
The sum of all of the above line items results in Cash Flow from
Financing
The sum of Cash Flow from Operations, Cash Flow from Investing and
Cash Flow from Financing equals net cash flow for the period and the
sum of net cash flow + the beginning cash balance equals the ending
cash balance

37
Cash Flow Statement Example

($ in millions) Fiscal Year Ending December 31,

2003 2004 2005
Cash flow from operating activities:
Net income $298.5 $337.2 $267.0
Depreciation and amortization 92.0 101.4 123.8
Deferred income taxes and other items 51.7 50.2 (72.2)
Provision for credit losses and bad debts 0.4 (0.3) 0.1
Changing in operating assets and liabilities:
Accounts and note receivable 17.2 (53.0) (68.2)
Inventories 202.3 (234.2) 38.8
Other current assets (5.2) (7.5) 28.5
Accounts payable, accrued expenses and income taxes
payable and other (5.0) 158.7 45.1
Net cash provided by operating activities 651.9 352.5 362.9
Cash flow from investing activities:
Additions to property, plant and equipment (189.6) (229.4) (170.7)
Proceeds from sale of property, plant and equipment 2.0 2.5 226.0
Other investing activities (1.3) (63.3) (16.0)
Net cash provided by (used in) investing activities (188.9) (290.2) 39.3
Cash flow from financing activities:
Purchases of treasury stock (286.2) (251.1) (625.8)
Sale of treasury stock to employee benefit plans 35.8 35.4 30.1
Proceeds from exercise of stock options 15.7 50.4 17.4
Payments of dividends (40.8) (39.7) (33.7)
Changes in short-term borrowings, net 20.7 (14.0) (4.0)
Repayments of long-term borrowings (20.0) (40.1) (0.1)
Net cash used in financing activities (274.8) (259.1) (616.1)
Net (decrease)/increase in cash and cash equivalents 188.2 (196.8) (213.9)
Cash and cash equivalents, beginning of period 446.5 634.7 437.9
Cash and cash equivalents, end of period $634.7 $437.9 $224.0

38
Table of Contents

I. Introduction to Accounting

II. Balance Sheet Overview

III. Income Statement Overview

IV. Cash Flow Statement Overview

V. Advanced Topics

39
Inventory

Valuing inventory
There are a number of different techniques that can be used to
value inventory, however, GAAP generally requires the technique
called lower-of-cost-or-market for most purposes
Lower-of-cost-or-market is the lower of (1) acquisition cost and (2)
market value (generally measured as replacement cost)
New inventory will generally be valued at cost
However, if, for example, inventory (e.g. raw materials) is held for a
long period, and the market value of the inventory declines, then the
firm will likely reduce the value (take a write-down) of inventory on
its balance sheet
Cost flow assumptions
Under the accrual basis, when revenue is realized, the associated
costs of producing that revenue (COGS) is also booked. There are
several methods for which firms can account for the cost of the
inventory that makes up COGS

40
Inventory

Cost flow assumptions (continued)

FIFO (First-in, first-out)
Under FIFO accounting the costs of the earliest units of inventory are
assigned to COGS and the costs of the most recent acquisitions of
inventory are assigned to ending inventory on the balance sheet
In other words, the firm uses the oldest materials and goods first
LIFO (Last-in, first-out)
Under LIFO accounting, the costs of the newest units of inventory are
assigned to COGS and the costs of the oldest acquisitions of inventory
are assigned to ending inventory
In a period of rising purchase prices, LIFO accounting results in higher
COGS, lower income and a low balance sheet value of inventory
Weighted Average
Under the weighted-average method, firms calculate the average of
the inventory value when applying this value to COGS and to inventory
value on the balance sheet

41
Taxes

The amount that a firm usually reports as income before taxes

for financial reporting usually differs from the amount of
taxable income that appears on the firms tax return
The two different types of accounting are often referred to as
book purposes (i.e. financial reporting) and tax purposes
Differences occur most often when book income includes
revenues or expenses in one accounting period and taxable
income includes them in a different period (these are known as
temporary differences)
Permanent differences, while less frequent, can also occur
A deferred tax liability will appear on the balance sheet when
a firm recognizes an expense earlier for tax reporting than for
financial reporting
A deferred tax asset will appear on the balance sheet when a
firm recognizes an expense earlier for financial reporting than
for tax reporting

42
Leases

Firms often, instead of purchasing or owning property or

equipment, enter into long-term leases for such property or
equipment
There are two methods of accounting for long-term leases:
the operating lease method and the capital lease method
Operating leases
In an operating lease, the owner of the property (lessor or
landlord) transfers only the rights to use the property for a
specified period of time. At the end of the lease, the lessee
returns the property to the owner. The lessee does not take any
risk of ownership of the assets
The rental expense is treated as an operating expense in the
income statement and there is no impact to the firms balance
sheet

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Leases

Capital leases
In a capital lease, the lessee assumes some of the risks of ownership and
enjoys some of the benefits. A lease will be treated as a capital lease if
any of the following conditions are met:
The lease term is greater than 75% of the property's estimated economic life
The lease contains an option to purchase the property for less than fair market
value
Ownership of the property is transferred to the lessee at the end of the lease
term
The present value of the lease payments exceeds 90% of the fair market value of
the property
Accounting rules treat capital leases as if the firm had purchased the
property
Both an asset and a liability is created on the balance sheet equal to the present
value of the lease expenses
Each period (i.e. year), (1) the asset (lease) is amortized and the asset value is
reduced on the balance sheet, (2) interest expense is realized on the income
statement, and (3) the liability on the balance sheet is reduced
Operating and capital leases methods differ only in the timing of
accounting entries but not in the amount of expense in aggregate

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Intangible Assets

Assets that have no physical form but provide future benefits are
known as intangible assets. These include:
Research costs
Advertising costs
Patents
Trade secrets
Trademarks and copyrights
Generally speaking, GAAP requires that expenditures for research and
development (the activity that creates trade secrets and patents) and
for advertising (the activity that creates trademarks and copyrights)
be expensed in the period the expenses are incurred
This is a controversial topic in accounting but the rationale is that the
benefits of R&D and advertising are too uncertain and difficult to measure
to warrant capitalizing them
Therefore, intangible assets will generally not appear on a firms balance
sheet if the activities associated with generating those assets were
carried out by the firm itself

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Intangible Assets

However, if such intangible assets are purchased by the firm,

either directly (e.g. the firm buys a patent from another firm)
or indirectly (the firm acquires such assets by acquiring
another firm) then intangible assets can be created and will
appear on the firms balance sheet
Accountants or appraisers will be brought in to value the
intangible assets as of the date of acquisition as well as to
determine the useful life of the intangible assets
Each reporting period (e.g. each year), the intangible asset
will be amortized according to its useful life, similar to the
way tangible assets are depreciated, and amortizable expense
will appear as an expense on the income statement

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Purchase Accounting

When one firm acquires all or substantially all of the shares of

another firm, GAAP stipulates how the combination is accounted for
on the buyers financial statements. This method is called the
purchase method
The acquired companys assets and liabilities are examined and adjusted
to fair market value as of the date of acquisition
This process is known as a purchase price allocation
Intangible assets are often created during this process
The balance sheets of the two companies are combined as of the date of
the acquisition
Any excess of the purchase price over the market values of the individual
assets less liabilities (equivalently, excess of the purchase price over the
book value of equity) becomes goodwill
Goodwill is considered an intangible asset but is no longer required to be
amortized each period
However, accounting rules do require that goodwill be tested at least annually
for impairment, and if impairment is found then goodwill is written down by the
amount of impairment and an expense on the income statement is realized

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